<PAGE>   1
                                                                                
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

                        FOR ANNUAL AND TRANSITION REPORTS
                     PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
(Mark One)

/X/      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934

         For the fiscal year ended December 31, 1997

/ /      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934

         For the transition period from _____________ to ________________

                         Commission file number 1-10113

                              HALSEY DRUG CO., INC.
             (Exact Name of Registrant as Specified in Its Charter)

               New York                                  11-0853640
   (State or Other Jurisdiction             (I.R.S. Employer Identification No.)
of Incorporation or Organization)

   695 North Perryville Road, Crimson Building No. 2, Rockford, Illinois  61107
               (Address of Principal Executive Offices)               (Zip Code)

Registrant's telephone number, including area code       (718) 467-7500

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class:                  Name of Each Exchange on Which Registered:
Common Stock, Par Value $0.01         The American Stock Exchange


Securities registered Pursuant to Section 12(g) of the Act:

                                      None

                                      None
                                (Title of Class)

         Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No__

         Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. / /

         As of March 16, 1998, the registrant had 13,708,081 shares of Common
Stock, par value $0.01, outstanding. Based on the closing price of the Common
Stock on March 16, 1998 ($3 1/16), the aggregate market value of the voting
stock held by non-affiliates of the registrant was approximately $32,933,000.

                       DOCUMENTS INCORPORATED BY REFERENCE
Document                                                  Where Incorporated
- --------                                                  ------------------
Proxy Statement for the 1998 Annual Meeting               Part III
of Shareholders

                                                                        


<PAGE>   2



                                                     CONTENTS


<TABLE>
<CAPTION>
                                                                                                            PAGE


PART I

<S>                                                                                                         <C>

Item 1.           Business                                                                                      2


Item 2.           Properties                                                                                   13


Item 3.           Legal Proceedings                                                                            14


Item 4.           Submission of Matters to a Vote of Security Holders                                          18


PART II


Item 5.           Market for Registrant's Common Equity and Related Stockholder
                  Matters                                                                                      19


Item 6.           Selected Financial Data                                                                      20


Item 7.           Management's Discussion and Analysis of Financial
                  Condition and Results of Operations                                                          22


Item 8.           Financial Statements and Supplementary Data                                                  28


Item 9            Changes in and Disagreement with Accountants on
                  Accounting and Financial Disclosure                                                          28


PART III


Item 10.          Directors and Executive Officers of the Registrant                                           29


Item 11.          Executive Compensation                                                                       29


Item 12.          Security Ownership of Certain Beneficial Owners and
                  Management                                                                                   29


Item 13.          Certain Relationships and Related Transactions                                               29


PART IV


Item 14.          Exhibits, Financial Statement Schedules and Reports
                  on Form 8-K                                                                                  30

                  Signatures                                                                                   35

                  Index to Consolidated Financial Statements                                                   36
</TABLE>



                                                                                


<PAGE>   3
                SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Report under the captions Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations," Item
1, "Business" and elsewhere in this Report constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995 (the "Reform Act"). Such forward-looking statements involve known and
unknown risks, uncertainties and other factors which may cause the actual
results, performance or achievements of Halsey Drug Co., Inc. ("Halsey" or the
"Company"), or industry results, to be materially different from any future
results, performance, or achievements expressed or implied by such
forward-looking statements. Such factors include, among others, the following:
changes in general economic and business conditions; loss of market share
through competition; introduction of competing services by other companies;
changes in industry capacity; pressure on prices from competition or from
purchasers of the Company's products; regulatory changes in the generic
pharmaceutical manufacturing industry; regulatory obstacles to the introduction
of new products are important to the Company's growth; availability of qualified
personnel; the loss of any significant customers; and other factors both
referenced and not referenced in this Report. When used in this Report, the
words "estimate," "project," "anticipate," "expect," "intend," "believe," and
similar expressions are intended to identify forward-looking statements.


                                                                                
                                       1


<PAGE>   4

                                     PART I


ITEM 1.  BUSINESS.

GENERAL

         The Company, a New York corporation established in 1935, and its
subsidiaries, are engaged in the manufacture, sale and distribution of generic
drugs. A generic drug is the chemical and therapeutic equivalent of a brand-name
drug for which patent protection has expired. A generic drug may only be
manufactured and sold if patents (and any additional government-granted
exclusivity periods) relating to the brand-name equivalent of the generic drug
have expired. A generic drug is usually marketed under its generic chemical name
or under a brand name developed by the generic manufacturer. The Company sells
its generic drug products under its Halsey label and under private-label
arrangements with drugstore chains and drug wholesalers. While subject to the
same governmental standards for safety and efficacy as its brand-name
equivalent, a generic drug is usually sold at a price substantially below that
of its brand-name equivalent.

         Halsey's wholly-owned subsidiaries include Houba, Inc. ("Houba"), an
Indiana corporation, Halsey Pharmaceuticals, Inc. ("Halsey Pharmaceuticals"), a
Delaware corporation, Indiana Fine Chemicals Corporation ("Indiana Chemicals"),
a Delaware corporation, H.R. Cenci Laboratories, Inc., a California corporation
(97% owned) ("Cenci Laboratories"), and Cenci Powder Products, Inc. ("Cenci
Powder"), a Delaware corporation. The Company also has two other subsidiaries,
Blue Cross Products, Inc., a New York corporation, and The Medi- Gum
Corporation, a Delaware corporation, each of which is inactive.

         The Company manufactures its products at facilities in New York and
Indiana. During 1995, in connection with the sale of its oxycodone with
acetaminophen tablet business, the Company began manufacturing such product for
a third party. See "Business-- Dispositions," below. During the last several
years, the Company has sought to diversify its businesses through strategic
acquisitions and through the development, manufacture and sale of bulk chemical
products used by others as raw materials in the manufacture of finished drug
forms.

RECENT EVENTS

         Regulatory Compliance

         During the past several years, the Company's business has been
adversely affected by the discovery of various manufacturing and record keeping
problems identified with certain products manufactured at its Brooklyn, New York
plant. In October 1991, the U.S. Food and Drug Administration (the "FDA") placed
the Company on the FDA's Application Integrity Policy list and its restrictions
(collectively, the "AIP"). Under the AIP, the FDA suspended all of the parent
company's applications for new drug approvals, including Abbreviate New Drug
Applications ("ANDAs") and Supplements to ANDAs. During the period that
followed, the U.S. Department of Justice ("DOJ") conducted an investigation into
the manufacturing and record keeping practices at the Company's Brooklyn plant.
As a consequence, on June 21, 1993, the Company entered into a plea agreement
(the "Plea Agreement") with the DOJ to resolve the DOJ's investigation. Under
the terms of the Plea Agreement, the Company agreed to plead guilty to five
counts of adulteration of a single drug product shipped in interstate commerce
and related record keeping violations. The Plea Agreement also required the
Company to pay a fine of $2,500,000 over five years in quarterly installments of
$125,000 commencing in September 1993. As of February 28, 1998, the Company was
in 

                                       2

<PAGE>   5
default of the payment terms of the Plea Agreement and had made payments
aggregating $350,000. On March 30, 1998, the Company and the DOJ signed a Letter
Agreement serving to amend the Plea Agreement relating to the terms of the
Company's satisfaction of the fine assessed under the Plea Agreement. The Letter
Agreement provides, among other things, that the Company will satisfy the
remaining $2,150,000 of the fine through the payment of $25,000 on a monthly
basis commencing May 1, 1998, plus interest on the outstanding balance. The
terms of the Letter Agreement are subject to the approval of the U.S. District
Court for the District of Maryland. Prior to the execution of the Letter
Agreement with the DOJ, the entire $2,150,000 balance of the fine payable to the
DOJ under the Plea Agreement had been classified as current. See "Item 3. Legal
Proceedings" and "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources" for a
more detailed description of the Letter Amendment to the Plea Agreement between
the DOJ and the Company.

         On June 29, 1993, the Company entered into a consent decree (the
"Consent Decree") with the U.S. Attorney for the Eastern District of New York on
behalf of the FDA that resulted from the FDA's investigation into the Brooklyn
plant's compliance with the FDA's Current Good Manufacturing Practices ("CGMP")
regulations. Under the terms of the Consent Decree, the Company was enjoined
from shipping any solid dosage drug products (i.e., excluding liquid drug
formulations) manufactured at the Brooklyn plant until the Company established,
to the satisfaction of the FDA, that the methods used in, and the facilities and
controls used for, manufacturing, processing, packing, labeling and holding any
drug, were established, operated, and administered in conformity with the
Federal Food, Drug, and Cosmetic Act and all CGMP Regulations. As part of
satisfying these requirements, the Company was required to validate the
manufacturing processes for each solid dosage drug product prior to
manufacturing and shipping the drug product.

         On October 23, 1996, the Company withdrew four of its ANDAs, including
its ANDA (the "Capsules ANDA") for acetaminophen/oxycodone capsules (the
"Capsules"), and halted sales of the affected products. Net sales derived from
the withdrawn Capsule ANDA were approximately $3 million and $8 million for the
years ended December 31, 1996 and December 31, 1995, respectively, and accounted
for approximately 24% and 40% of the Company's total net sales during such
twelve month periods. The Company instituted the withdrawal of the Capsule ANDA
at the suggestion of the FDA and in anticipation of its release from the AIP. At
the FDA's suggestion, the Company retained outside consultants to perform
validity assessments of its drug applications. Thereafter, in October 1996, the
FDA recommended that several applications, including the Capsule ANDA, be
withdrawn. As a basis for its decision, the FDA cited questionable and
incomplete data submitted in connection with the applications. The FDA indicated
that the withdrawal of the four ANDAs was necessary for the release of the
Company from the AIP. The FDA further required submission by the Company of a
Corrective Action Plan, which was prepared and submitted by the Company and
accepted by the FDA.

         On December 19, 1996, the FDA released the Company from the AIP. As a
consequence, for the first time since October 1991, the Company was permitted to
submit ANDAs to the FDA for review. Since its release from the AIP in December
1996, through the fiscal year ended December 31, 1997, the Company submitted six
ANDAs for review by the FDA, including a new ANDA with respect to the Capsules.
During the period from the Company's release from the AIP to March 15, 1998, the
Company received the following ANDA approvals, all of which relate to ANDA
filings made with the FDA subsequent to the Company's release from the AIP:



                                                                                
                                        3


<PAGE>   6

<TABLE>
<CAPTION>
Product Name
(Drug Class)                                         Strength          Trade Name           Status
                                                                                            
<S>                                                  <C>               <C>                  <C>  
Hydrocodone Bitartate                                                                       
and Acetaminophen Tablets                            5mg/500mg         Vicodin (1)          FDA approval of ANDA
(narcotic analgesic)                                                                        received September 26,
                                                                                            1997.
                                                                                            
Hydrocodone Bitartate                                                                       
and Acetaminophen Tablets                            7.5mg/750mg       VicodinES(R)(1)      FDA approval of ANDA
(narcotic analgesic)                                                                        received September 26,
                                                                                            1997.
                                                                                            
Hydrocodone Bitartate                                                                       
and Acetaminophen Tablets, CIII                      7.5mg/650mg       Lorcet Plus(R)(2)    FDA approval of
(narcotic analgesic)                                                                        ANDA received
                                                                                            November 26, 1997.
                                                                                            
Hydrocodone Bitartrate                                                                      
and Acetaminophen Tablets, CIII                      10mg/650mg        Lorcet(R)(2)         FDA approval of
(narcotic analgesic)                                                                        ANDA received November
                                                                                            26, 1997.
                                                                                            
Oxycodone HCI                                                                               
and Acetaminophen Capsules, CII                      5mg/50mg          Tylox(R)(3)          FDA approval of
(narcotic analgesic)                                                                        ANDA  received January
                                                                                            22, 1998.                    
</TABLE>



- -----------------------
(1)      Registered trademark of Knoll Pharmaceutical Co.

(2)      Registered trademark of Forest Laboratories, Inc.

(3)      Registered trademark of McNeil Consumer Products Company



                                                                                
                                        4


<PAGE>   7
         As of March 15, 1998, the Company had submitted two ANDAs for review by
the FDA in fiscal 1998 and anticipates the submission of eight additional ANDAs
during the balance of fiscal 1998. Although the Company has been successful in
receiving the ANDA approvals described above since its release from the AIP in
December 1996, there can be no assurance that any of its newly submitted ANDAs,
or those contemplated to be submitted, will be approved by the FDA. The Company
will not be permitted to market any new product unless and until the FDA
approves the ANDA relating to such product. Failure to obtain FDA approval for
the Company's pending ANDAs, or a significant delay in obtaining such approval,
would adversely affect the Company's business operations and financial
condition.

         Private Offering

         On March 10, 1998, the Company completed a private offering of
securities (the "Offering") to Galen Partners, III , L.P., Galen Partners
International III, L.P., Galen Employee Fund III, L.P., (collectively, "Galen")
and each of the Purchasers listed on the signature page to a certain Debenture
and Warrant Purchase Agreement dated March 10, 1998 between the Company and such
Purchasers (inclusive of Galen, collectively the "Galen Investor Group"). The
securities issued in the Offering consisted of 5% convertible senior secured
debentures (the "Debentures") and common stock purchase warrants (the
"Warrants") exercisable for an aggregate of 4,202,020 shares of the Company
common stock. The net proceeds to the Company from the Offering , after the
deduction of related Offering expenses, was approximately $19.6 million .

         Immediately prior to the completion of the Offering, the Company was
attempting to address various actions and proceedings which threatened the
Company's continuing operations, most of which stemmed from the Company's lack
of working capital to satisfy outstanding liabilities. In particular, the
Company's Banks had given notice of a forced sale of certain of their security
relating to the Company's outstanding bank indebtedness, which would have
resulted in the loss of Houba's Indiana facility. In addition, the landlord of
the Company's Brooklyn facility had served the Company with a notice of eviction
and various creditors had obtained judgments against the Company and filed
restraining notices against its bank accounts. A lack of funding also resulted
in the Company being unable to purchase meaningful quantities of raw materials
and left inventories depleted and sales reduced.

         The net proceeds of the Offering have, in large part, been used to
satisfy a substantial portion of the Company's liabilities and accounts payable.
Such liabilities include the full satisfaction of the Company's Bank
indebtedness and related fees, payment to the landlord of the Brooklyn facility
and satisfaction of outstanding judgments and liens. Such repayments have
allowed the Company to avoid the threatened foreclosure sale by its Banks of the
Indiana facility securing such indebtedness. Additionally, pursuant to
agreements reached with other large creditors in anticipation of the completion
of the Offering, including the Company's landlord and the DOJ, the Company has
been able to bring these creditors current and will be in compliance with
installment payment agreements providing favorable terms to the Company.
Satisfaction of the Company's current obligations to its landlord of the
Brooklyn facility for accrued and unpaid rent, penalties and expenses has
allowed the Company to renegotiate its lease and avoid eviction. The Offering
proceeds will also allow the Company to satisfy its outstanding state and
Federal payroll tax obligations and meet current payroll tax obligations.

         After giving effect to the application of the net proceeds of the
Offering, and based on Management's belief as to the Company's ability to defer
a portion of the Company's remaining notes and accounts payable and certain
other assumptions, the Company believes that it will have working capital of
approximately $3

                                       5

<PAGE>   8
million. See "Item 7. Management's Discussion and Analysis of the Financial
Condition and Results of Operations--Liquidity and Capital Resources."

         Under the rules of the American Stock Exchange ("AMEX") on which the
Company's shares are listed for trading, the Company was required to obtain the
approval of its shareholders in order to complete the Offering. In view of the
Company's financial condition, its need for immediate capital and the delay
associated with soliciting the approval of its shareholders, the Company
requested a waiver from the AMEX in order to complete the Offering without the
necessity of obtaining shareholder approval. In requesting the waiver, the
Company provided detailed information, including a written submission, to the
AMEX and met with representatives of the AMEX to discuss the proposed terms of
the Offering, the experience of new Senior Management, Galen's investment
history and the urgent need to complete the Offering on or before March 11, 1998
in order to allow for the payment of the liabilities previously described, some
of which threatened to cease the Company's continuing operations.

         The AMEX granted the Company's request for the waiver from its
shareholder approval requirement in connection with the Offering in order to
permit its timely completion. As part of this process, the AMEX suspended
trading in the Company stock commencing Friday, March 6, 1998. Trading on the
AMEX resumed on Monday, March 16, 1998 following the circulation on March 11,
1998 of a Press Release to the Company's shareholders of record describing the
terms of the Offering and its completion on March 10, 1998. Such press release
was also distributed over the wire services on Friday, March 13, 1998.

         Reference is made to the Company's Current Report on Form 8-K as filed
with the Securities and Exchange Commission on March 24, 1998 which describes,
among other things, the Offering and the terms of the Debentures and Warrants
issued in the Offering. The Form 8-K is incorporated herein by this reference
and attached as Exhibit 10.41 hereto.

         Cessation of California Operations

         On March 20, 1998, the Company discontinued the operation of Cenci
Laboratories. Cenci Laboratories had been a manufacturer of drug products in
liquid and powder preparations. Continuing operating losses and the Company's
inability to leverage the manufacturing capacity of Cenci Laboratories were
among factors considered by the Board and Management in its determination to
cease such operations.

         On March 26, 1998, the Company signed a Letter of Intent with Zuellig
Botanicals for the sale of substantially all of the non-real property assets of
Cenci Powder. The Letter of Intent provides that the purchase price for the
assets will consist of the forgiveness by Zuellig Botanicals of approximately
$262,000 in indebtedness owed by Cenci Powder to Zuellig Botanicals related to
the purchase of raw materials. The Letter of Intent provides further that
Zuellig Botanicals will satisfy the manufacture and delivery requirements of
Cenci Powder at its located facility in Fresno, California, under an existing
third party supply contract. Additionally, the Letter Agreement contemplates a
right of first refusal in favor of an affiliate of Zuellig Botanicals to supply
the Company's raw material requirements for the production of doxycycline. The
terms of the Letter Intent are subject to the negotiation and execution of
definitive purchase agreements, of which there can be no assurance. It is the
Company's intent to dispose of the real property owned by Cenci Powder in
Fresno, California in the ordinary course. Continuing operating losses and the
Company's 

                                       6

<PAGE>   9
inability to leverage the manufacturing capacity of Cenci Powder were among the
factors considered by the Board and Management in its determination to terminate
the operations of Cenci Powder.

PRODUCTS AND PRODUCT DEVELOPMENT

         Generic Drug Products

         The Company historically has manufactured and sold a broad range of
prescription and over-the-counter drug products. The Company's pharmaceutical
product list currently includes a total of approximately 27 products, consisting
of 18 dosage forms and strengths of prescription drugs and 9 dosage forms and
strengths of over-the-counter drugs. Each dosage form and strength of a
particular drug is considered in the industry to be a separate drug product. The
Company's drug products are sold in various forms, including liquid and powder
preparations, compressed tablets and two-piece, hard-shelled capsules.

         Most of the generic drug products manufactured by the Company can be
classified within one of the following categories:

         1.       Antibiotics,

         2.       Narcotic analgesics,

         3.       Anti-infective and anti-tubercular drugs,

         4.       Antihistamines and antihistaminic decongestants, or

         5.       Antitussives.

         During fiscal 1997, sales of antitussives and narcotic analgesics
accounted for approximately 90% of total net sales during such year. The Company
anticipates that sales of antitussives and narcotic analgesics will continue to
represent a significant portion of the Company's revenue.

         The Company's development strategy for new drug products has been to
focus on the development of a broad-range of generic form drugs, each of which
(i) has developed a solid market acceptance with a wide base of customers, (ii)
can be sold on a profitable basis notwithstanding intense competition from other
drug manufacturers, and (iii) is no longer under patent protection. The Company
has also diversified its current product line to include some less widely
prescribed drugs as to which limited competition might be expected. In addition,
the Company will continue to pursue the development of its existing
pharmaceutical business as well as the development of the chemical products
business of its Houba subsidiary.

         Development activities for each new generic drug product begin several
years in advance of the patent expiration date of the brand-name drug
equivalent. This is because the profitability of a new generic drug usually
depends on the ability of the Company to obtain FDA approval to market that drug
product upon or immediately after the patent expiration date of the equivalent
brand-name drug. Being among the first to market a new generic drug product is
vital to the profitability of the product. As other off-patent drug
manufacturers receive FDA approvals on competing generic products, prices and
revenues typically decline. Accordingly, the Company's ability to attain
profitable operations will, in large part, depend on its ability to develop and
introduce new products, the timing of receipt of FDA approval of such products
and the number and timing of FDA approvals for competing products.

                                       7

<PAGE>   10
         Bulk Chemical Products

         In the last few years, the Company has increased its efforts to
develop, manufacture and market bulk chemical products. The development and sale
of bulk chemicals is generally not subject to the same level of regulation as is
the development and sale of drug products; accordingly, chemicals may be brought
to market substantial sooner than drug products.

         Dispositions

         On March 21, 1995 (the "Closing Date"), the Company sold to
Mallinckrodt its Tablets ANDA for 5 mg Oxycodone HCI/325 mg Acetaminophen
tablets ("Tablets"), and certain pieces of equipment utilized in connection with
its production activities under the Tablets ANDA, for up to $5.4 million (the
"Purchase Price"). Mallinckrodt paid the Company $2 million of the Purchase
Price on the Closing Date, having previously paid $500,000 in July 1994. The
$2.9 million balance of the Purchase Price (the "Deferred Payment") was payable
as follows. Mallinckrodt paid $1 million on January 9, 1997, following the
Company's release from the AIP program. In connection with the transaction,
Mallinckrodt agreed to defer $1.2 million of the Company's trade debt due to an
affiliate of Mallinckrodt. The deferred indebtedness was evidenced by a
promissory note (the "Note") with interest accruing at a rate of 8% per annum.
On September 21, 1997 Mallinckrodt offset a portion of its remaining Deferred
Payment obligations against the amount due on the Note. The remaining portion of
the Deferred Payment has been satisfied and the purchase transaction has been
finalized.

         In connection with the sale of the Tablets ANDA, the Company agreed to
manufacture Tablets for Mallinckrodt for a period of three years and
Mallinckrodt agreed to order a minimum number of Tablets from the Company for
the two year period following the Closing Date. The Company and Mallinckrodt
also entered into a non-competition agreement pursuant to which the Company
agreed not to compete with Mallinckrodt and its affiliates in the United States
with respect to the Tablets ANDA until March 21, 2000. If, prior to the time it
is possible for Mallinckrodt to commence production under the Tablets ANDA or
any new Tablets ANDA at its own facility, the Company ceases or is forced to
cease or substantially curtail production under the Tablets ANDA, as a
consequence of (i) any action or communication by the FDA or any other
regulatory or governmental authority or (ii) any financial or other business
difficulty, then Mallinckrodt has the right to a full refund of any portion of
the Deferred Payment already made to the Company. During fiscal 1997,
approximately $2,024,000 of the Company's revenues (approximately 22%) were
derived from the toll manufacturing agreement with Mallinckrodt for the Tablets.

         In connection with the sale of the Tablets ANDA, the Company issued to
Mallinckrodt an option exercisable at any time until March 21, 1998 (the "Option
Exercise Date"), to purchase the Capsule ANDA at an exercise price equal to 75%
of Net Capsule Revenue, subject to downward adjustment in the event of a decline
in pricing levels. Mallinckrodt did not exercise its option to purchase the
Tablets ANDA prior to the Option Exercise Date.

         Acquisitions

         The Company has engaged Penick Corporation ("Penick") to process
certain of the raw materials utilized in the production of
acetaminophen/oxycodone tablets. In order to ensure the continued viability of
Penick, the Company's Houba subsidiary purchased a 25% equity interest in
Penick in mid-1993. In addition, in September 1995, Houba purchased an 8.3%
equity interest in Penick Pharmaceutical, Inc., which owns the other 75% of
Penick. In May 1996, the Company advanced Penick approximately $250,000 in 

                                       8

<PAGE>   11
order to continue the supply of raw materials for the production of
acetaminophen/oxycodone capsules. In June 1994, both Penick Corporation and
Penick Pharmaceutical, Inc, filed petitions under Chapter 11 of the United
States Bankruptcy Code. During the first quarter of 1997, the Company ceased
purchasing raw materials from Penick in favor of a new raw material supplier.
See "Raw Materials."

RESEARCH AND DEVELOPMENT

         The Company conducts research and development activities at each of its
Brooklyn and Indiana facilities. The Company's research and development
activities consist primarily of new generic drug product development efforts and
manufacturing process improvements, as well as the development for sale of new
chemical products. New drug product development activities are primarily
directed at conducting research studies to develop generic drug formulations,
reviewing and testing such formulations for therapeutic equivalence to brand
name products and additional testing in areas such as bioavailability,
bioequivalence and shelf-life. For fiscal years 1997, 1996 and 1995, total
research and development expenditures were $979,000, $1,854,000 and $818,000
respectively. During 1998 the Company intends to concentrate its research and
development efforts in the areas of pain management and steroids:

         As of March 15, 1998, the Company maintained a full-time staff of two
and a part-time staff of six in its Research and Development Departments.

MARKETING AND CUSTOMERS

         The application of the AIP to the Company's operations until December
1996, combined with the Company's continuing operating losses and lack of
adequate working capital during fiscal 1997 resulted in the Company's inability
to maintain sufficient raw materials and finish goods inventories to permit the
Company to actively solicit customer orders, and when orders were received, to
fill such orders promptly. Following the completion of the Offering, new
Management adopted a marketing strategy focused on developing and maintaining
sufficient raw materials and finish goods inventories so as to permit a targeted
sales effort by the Company to a core customer group, with an emphasis on
quality, prompt product delivery and excellent customer service. In this regard,
the Company has recently hired Stephanie Heitmeyer to serve as Vice President of
Sales. The Company believes this addition will substantially enhance the
Company's marketing and sales efforts and complement the Company's existing two
salaried sales persons. The Company's products are, in large part, be sold by
such sales persons and, to a lesser extent, through one independent sales
representative, who is compensated on a commission basis. The Company is also
considering the addition of one additional independent sales representative.
Sales of the Company's drugs in dosage form are made primarily to drug
wholesalers, drugstore chains, distributors and other manufacturers and are not
concentrated in any specific region.

         During 1997, the Company had net sales to one customer in excess of 10%
of total sales, aggregating 22.3% of total sales, and sales to a second
customer aggregating 9.8% of total sales. The Company believes that the loss of
this customer would have a material adverse effect on the Company. During 1996,
the Company had net sales to one customer in excess of 10% of total sales,
aggregating 10% of total sales. During 1995, the Company had net sales to two
customers in excess of 10% of total sales, each aggregating 25% and 11% of
total sales, respectively.

         The estimated dollar amount of the backlog of orders for future
delivery as of March 15, 1998 was approximately $800,000 as compared with
approximately $3,560,000 as of February 28, 1997. Although these orders are
subject to cancellation, management expects to fill substantially all orders by
the second quarter of 1998.

                                       9

<PAGE>   12
GOVERNMENT REGULATION

         General

         All pharmaceutical manufacturers, including the Company, are subject to
extensive regulation by the Federal government, principally by the FDA, and, to
a lesser extent, by state and local governments. The Company cannot predict the
extent to which it may be affected by legislative and other regulatory
developments concerning its products and the healthcare industry generally. The
Federal Food, Drug, and Cosmetic Act, the Generic Drug Enforcement Act of 1992,
the Controlled Substance Act and other Federal statutes and regulations govern
or influence the testing, manufacture, safe labeling, storage, record keeping,
approval, pricing, advertising, promotion, sale and distribution of
pharmaceutical products. Noncompliance with applicable requirements can result
in fines, recall or seizure of products, criminal proceedings, total or partial
suspension of production, and refusal of the government to enter into supply
contracts or to approve new drug applications. The FDA also has the authority to
revoke approvals of new drug applications. Recent changes in FDA procedures have
increased the time and expense involved in obtaining ANDA approvals and in
complying with the FDA's CGMP standards. The ANDA drug development and approval
process now averages approximately eight months to two years. The approval
procedures are generally costly and time consuming.

         FDA approval is required before any "new drug," whether prescription or
over-the-counter, can be marketed. A "new drug" is one not generally recognized
by qualified experts as safe and effective for its intended use. Such general
recognition must be based on published adequate and well controlled clinical
investigations. Generally, a drug which is the generic equivalent of a
previously approved prescription drug will be treated as a new drug requiring
FDA approval. Furthermore, each dosage form of a specific generic drug product
requires separate approval by the FDA. However, as discussed below, less costly
and time consuming approval procedures may be used for generic equivalents.
Among the requirements for drug approval is that the prospective manufacturer's
methods must conform to the CGMPs. CGMPs apply to the manufacture, receiving,
holding and shipping of all drugs, whether or not approved by the FDA. CGMPs
must be followed at all times during which the drug is manufactured. To ensure
full compliance with standards, some of which are set forth in regulations, the
Company must continue to expend time, money and effort in the areas of
production and quality control. Failure to so comply risks delays in approval of
drugs, disqualification from eligibility to sell to the government, and possible
FDA enforcement actions, such as an injunction against shipment of the Company's
products, the seizure of noncomplying drug products, and/or, in serious cases,
criminal prosecution. The Company's manufacturing facilities are inspected on a
regular basis by the FDA and by consultants retained by the Company to perform
self-auditing functions to ensure compliance on an ongoing basis with CGMPs. See
also Item 3. "Legal Proceedings."

         In addition, products marketed outside the United States, but which are
manufactured inside the United States, are subject to certain FDA regulations,
as well as regulation by the country in which the products are to be sold.

         In addition to the regulatory approval process, the Company is subject
to regulation under Federal, state and local laws, including requirements
regarding occupational safety, laboratory practices, environmental protection
and hazardous substance control, and may be subject to other present and future
local, state, Federal and foreign regulations, including possible future
regulations of the pharmaceutical industry.

         Drug Approvals

                                       10

<PAGE>   13

         There are currently three ways to obtain FDA approval of a new drug.

         1.       New Drug Applications ("NDA"). Unless one of the procedures
                  discussed in paragraph 2 or 3 below is available, a
                  prospective manufacturer must conduct and submit to the FDA
                  complete clinical studies to prove a drug's safety and
                  efficacy, in addition to the bioavailability and/or
                  bioequivalence studies discussed below, and must also submit
                  to the FDA information about manufacturing practices, the
                  chemical make-up of the drug and labeling.

         2.       Abbreviated New Drug Applications ("ANDA"). The Drug Price
                  Competition and Patent Term Restoration Act of 1984 (the "1984
                  Act") established the ANDA procedure for obtaining FDA
                  approval for those drugs that are off-patent or whose
                  exclusivity has expired and that are bioequivalent to
                  brand-name drugs. An ANDA is similar to an NDA, except that
                  the FDA waives the requirement of conducting complete clinical
                  studies of safety and efficacy, although it may require
                  expanded clinical bioavailability and/or bioequivalence
                  studies. "Bioavailability" means the rate of absorption and
                  levels of concentration of a drug in the blood stream needed
                  to produce a therapeutic effect. "Bioequivalence" means
                  equivalence in bioavailability between two drug products. In
                  general, an ANDA will be approved only upon a showing that the
                  generic drug covered by the ANDA is bioequivalent to the
                  previously approved version of the drug, i.e., that the rate
                  of absorption and the levels of concentration of a generic
                  drug in the body are substantially equivalent to those of a
                  previously approved equivalent drug. The principal advantage
                  of this approval mechanism is that an ANDA applicant is not
                  required to conduct the same preclinical and clinical studies
                  to demonstrate that the product is safe and effective for its
                  intended use.

                  The 1984 Act, in addition to establishing the ANDA procedure,
                  created new statutory protections for approved brand-name
                  drugs. In general, under the 1984 Act, approval of an ANDA for
                  a generic drug may not be made effective until all relevant
                  product and use patents for the equivalent brand name drug
                  have expired or have been determined to be invalid. The only
                  exceptions are situations in which the ANDA applicant
                  challenges the validity or applicability of the patent and
                  either the patent holder does not file suit or litigation
                  extends more than 30 months after notice of the challenge was
                  received by the patent holder. Prior to enactment of the 1984
                  Act, the FDA gave no consideration to the patent status of a
                  previously approved drug. Additionally, under the 1984 Act, if
                  specific criteria are met, the term of a product or use patent
                  covering a drug may be extended up to five years to compensate
                  the patent holder for the reduction of the effective market
                  life of that patent due to federal regulatory review. With
                  respect to certain drugs not covered by patents, the 1984 Act
                  sets specified time periods of two to ten years during which
                  approvals of ANDAs for generic drugs cannot become effective
                  or, under certain circumstances, ANDAs cannot be filed if the
                  equivalent brand-name drug was approved after December 31,
                  1981.

         3.       Alternative New Drug Applications. An alternative NDA
                  procedure is provided by the 1984 Act whereby the applicant
                  may rely on published literature and more limited testing
                  requirements. That alternative seldom provides advantages over
                  the ANDA procedure, however, and is accordingly rarely used.

         Generic Drug Enforcement Act

                                       11

<PAGE>   14
         As a result of hearings and investigations concerning the activities of
the generic drug industry and the FDA's generic drug approval process, Congress
enacted the Generic Drug Enforcement Act of 1992 (the "Generic Drug Act"). The
Generic Drug Act confers significant new authority upon the FDA to impose
debarment and civil penalties for individuals and companies who commit certain
illegal acts relating to the generic drug approval process.

         The Generic Drug Act requires the mandatory debarment of companies or
individuals convicted of a federal felony for conduct relating to the
development or approval of any ANDA, and gives the FDA discretion to debar
corporations or individuals for similar conduct resulting in a federal
misdemeanor or state felony conviction. The FDA may not accept or review during
the period of debarment (one to ten years in the case of mandatory, or up to
five years in the case of permissive, debarment of a corporation) any ANDA
submitted by or with the assistance of the debarred corporation or individual.
The Generic Drug Act also provides for temporary denial of approval of generic
drug applications during the investigation of crimes that could lead to
debarment. In addition, in more limited circumstances, the Generic Drug Act
provides for suspension of the marketing of drugs under approved generic drug
applications sponsored by affected companies. The Generic Drug Act also provides
for fines and confers authority on the FDA to withdraw, under certain
circumstances, approval of a previously granted ANDA if the FDA finds that the
ANDA was obtained through false or misleading statements. The Company was not
debarred as a result of the FDA investigation and settlement and the Consent
Decree with the FDA makes no provision therefor.

         Healthcare Reform

         Several legislative proposals to address the rising costs of healthcare
have been introduced in Congress and several state legislatures. Many of such
proposals include various insurance market reforms, the requirement that
businesses provide health insurance coverage for all their employees,
significant reductions in the growth of future Medicare and Medicaid
expenditures, and stringent government cost controls that would directly control
insurance premiums and indirectly affect the fees of hospitals, physicians and
other healthcare providers. Such proposals could adversely affect the Company's
business by, among other things, reducing the demand, and the prices paid, for
pharmaceutical products such as those produced and marketed by the Company.
Additionally, other developments, such as (i) the adoption of a nationalized
health insurance system or a single payor system, (ii) changes in needs-based
medical assistance programs, or (iii) greater prevalence of capitated
reimbursement of healthcare providers, could adversely affect the demand for the
Company's products.

COMPETITION

         The Company competes in varying degrees with numerous companies in the
health care industry, including other manufacturers of generic drugs (among
which are divisions of several major pharmaceutical companies) and manufacturers
of brand-name drugs. Many of the Company's competitors have substantially
greater financial and other resources and are able to expend more money and
effort than the Company in areas such as marketing and product development.
Although a company with greater resources will not necessarily receive FDA
approval for a particular generic drug before its smaller competitors,
relatively large research and development expenditures enable a company to
support many FDA applications simultaneously, thereby improving the likelihood
of being among the first to obtain approval of at least some generic drugs.

         One of the principal competitive factors in the generic pharmaceutical
market is the ability to introduce generic versions of brand-name drugs promptly
after a patent expires. The Company believes that 

                                       12

<PAGE>   15
it was at a competitive disadvantage until its release from the AIP program and
the FDA's resumption of review of ANDAs submitted by the Company's Brooklyn
plant. See "Government Regulation--Generic Drug Enforcement Act" above. Other
competitive factors in the generic pharmaceutical market are price, quality and
customer service (including maintenance of sufficient inventories for timely
deliveries).

RAW MATERIALS

         The raw materials essential to the Company's business are bulk
pharmaceutical chemicals purchased from numerous sources. Raw materials are
generally available from several sources. The Federal drug application process
requires specification of raw material suppliers. If raw materials from a
supplier specified in a drug application were to become unavailable on
commercially acceptable terms, FDA supplemental approval of a new supplier would
be required. During 1997, the Company purchased approximately $1,187,000 of its
raw materials (constituting 24.7% of its aggregate purchases of raw materials)
from Mallinckrodt. Although the Company is now able to submit Supplements to the
FDA in order to allow the Company to purchase raw materials from alternate
sources, there can be no assurance that if the Company were unable to continue
to purchase raw materials from this supplier, that the Company would be
successful in receiving FDA approval to such Supplement or that it would not
face difficulties in obtaining raw materials on commercially acceptable terms.
Failure to receive FDA approval for, and to locate, an acceptable alternative
source of raw materials would have a material adverse effect on the Company.

         The United States Drug Enforcement Administration (the "DEA") limits
the quantity of the Company's inventories of certain raw materials used in the
production of controlled substances based on historical sales data. In view of
the Company's recently depressed sales volume, these DEA limitations could
increase the likelihood of raw material shortages and of manufacturing delays in
the event the Company experiences increased sales volume or is required to find
new suppliers of these raw materials.

EMPLOYEES

         As of March 15, 1998, the Company had approximately 142 full-time
employees. Approximately 30 are administrative and professional personnel and
the balance are in production and shipping. Among the professional personnel, 2
are engaged in research and product development. Approximately 65 employees at
the Company's Brooklyn plant are represented by a local collective bargaining
unit. The collective bargaining agreement between the Company and the union was
extended on March 5, 1998 (retroactive to July 2, 1997) and expires June 30,
2000. Management believes that its relations with its employees and the union
are satisfactory.


I
TEM 2. PROPERTIES

         Halsey leases, as sole tenant, a total of approximately 112,300 square
feet, in three buildings on Pacific Street and Dean Street in Brooklyn, New
York. Each of these leases is between Halsey and unaffiliated lessors. The
approximate aggregate minimum rental commitments under these operating leases
are as follows: $928,000 for the year 1996, $975,000 for the year 1997 and
$1,029,000 for the year 1998. As part of the completion of the Offering, the
Company settled a pending proceeding with its landlord for the Brooklyn facility
to, among other things, satisfy rent arrearages, penalties and other charges and
to delete certain prior amendments to the Lease Agreements requiring more
frequent rental payments and the imposition of substantial penalties. These
leases expire on December 31, 2005. The buildings leased by Halsey in Brooklyn
house its research and development and manufacturing facilities.

                                       13

<PAGE>   16
         Halsey leases approximately 4,700 square feet of office space located
at 695 North Perryville Road, Building No. 2, Rockford, Illinois. The lease is
between the Company and an unaffiliated lessor. The lease has a term of two
years expiring March 30, 2000 and calls for annual rental, including
maintenance and common area expense, of approximately $50,000 per year. The
Company is in the process of making necessary leasehold improvements and
additions of computer and office furniture and equipment in order to operate
the Company's principal executive offices from this location, including its
sales, administration and finance operations.

         Houba owns approximately 45,000 square feet of building space on
approximately 30 acres of land in Culver, Indiana, which includes a 15,000
square foot manufacturing facility. This manufacturing facility houses separate
plants for the production of Doxycycline raw materials, Doxycycline capsules and
tablets and Biotin raw materials. In 1996, in conjunction with a settlement with
two former employees, the Company acquired real property, improved by a
residential property, in Culver, Indiana adjacent to the manufacturing facility.
The Company became the lessor of the residential property upon closing of the
acquisition.

         Cenci Laboratories and Cenci Powder together own approximately 6,700
square feet of manufacturing and distribution building space located on
approximately one-half acre in Fresno, California. In addition, Cenci
Laboratories and Cenci Powder lease approximately 18,000 square feet of space in
a building located in Fresno, California used for manufacturing and corporate
offices. This lease is currently on a month-to-month basis and is anticipated to
be terminated on or about May 31, 1998 as part of the cessation of the Cenci
Laboratories and Cenci Powder operations. See "Item 1. Business - Recent Events
- - Cessation of California Operations." During the years ended December 31, 1997,
1996 and 1995, Cenci and Cenci Powders paid an aggregate of $90,000, $90,000 and
$86,000 respectively, to a former officer of Cenci Laboratories and Cenci Powder
in respect of this lease.

         The Company also leases office space in Westwood, New Jersey for its
marketing and sales departments on a year-to-year basis. It is anticipated that
this lease will be terminated on April 30, 1998 as part of the relocation of the
Company's corporate headquarters to Rockford, Illinois.


ITEM 3. LEGAL PROCEEDINGS.

GOVERNMENT CONSENT DECREES

         On June 21, 1993, the Company entered into a Plea Agreement with the
DOJ to resolve the DOJ's investigation into the manufacturing and record keeping
practices of the Company's Brooklyn plant. Under the terms of the Plea
Agreement, the Company agreed to plead guilty to five counts of adulteration of
drug products shipped in interstate commerce. Each count involved product
adulteration and record keeping deficiencies relating to a single drug product,
Quinidine Gluconate (324mg tablets), manufactured at the Brooklyn plant. The
Plea Agreement also required the Company to pay a fine of $2,500,000 over five
years in quarterly installments of $125,000, commencing on or about September
15, 1993. The Company's plea was entered and the terms of the Plea Agreement
were approved by the United States District Court for the District of Maryland
on July 16, 1993. As of February 28, 1998, the Company was in default of the
payment terms of the Plea Agreement and had made payments aggregating $350,000.
On March 30, 1998, the Company and the DOJ signed a Letter Agreement serving to
amend the Plea Agreement relating to the terms of the Company's satisfaction of
the fine assessed under the Plea Agreement. Specifically, the Letter Agreement
provides that the Company will satisfy the remaining $2,150,000 of the fine
through the payment of $25,000 on a monthly basis commencing May 1, 1998, plus
interest on such outstanding balance (at the 

                                       14

<PAGE>   17
rate calculated pursuant to 28 U.S.C. Section 1961)(currently 5.319%). Such
payment schedule will result in the full satisfaction of the DOJ fine in
December, 2005. The Letter Agreement also provides certain restrictions on the
payment of salary or compensation to any individual in excess of $150,000
without the written consent of the United States District Court for the District
of Maryland, subject to certain exceptions. In addition, the Letter Agreement
requires the prepayment of the outstanding fine to the extent of 25% of the
Company's after tax profit and 25% of the net proceeds received by the Company
on any sale of a capital asset for a sum in excess of $10,000. The terms of the
Letter Agreement are subject to the approval of the U.S. District Court for the
District of Maryland.

         See "Item 1. Business - Recent Events" for information regarding the
release of the Company from the FDA's AIP program and resumption by the FDA of
review of ANDAs filed by the Company.

OTHER GOVERNMENTAL PROCEEDINGS

         By letter dated October 23, 1995, the Company was notified by the New
York State Education Department (the "Department") that the Professional Conduct
Officer of the Office of Professional Discipline had determined that there was
sufficient evidence of professional misconduct on the Company's part to warrant
a disciplinary proceeding under New York law. Upon contacting the Deputy
Director of the Office of Professional Discipline, counsel for the Company was
advised that the alleged misconduct related to the same activities that were the
subject of the DOJ investigation. The Company submitted a written response to
the Department on November 16, 1995. The Company and the Department entered into
a consent order effective July 18, 1997, concluding any disciplinary
proceedings. The consent order requires that the Company pay $175,000 in fines
over a period of five years. The consent order also provides that the Company's
registration as a manufacturer of drugs in New York State is revoked, but such
revocation is stayed and the Company has been placed on probation for a maximum
period of five years. The Company has the right to apply for removal from
probation two years after the effective date of the consent order.

         Immediately prior to the completion of the Offering, the Company was in
default under the consent order with the Department for failure to satisfy two
of the monthly installments of the fine as provided in the consent order. Prior
to the completion of the Offering, the Company advised the Department as to the
existence of the default and that such deficiencies would be corrected upon the
completion of the Offering. The Company has satisfied these outstanding amounts
and is now current under the consent order with the Department. Based on
discussions between representatives of the Department and the Company's outside
counsel handling this matter, the Company has been advised that the revocation
of the Company's registration as a manufacturer of drugs in the State of New
York will remain stayed and that the Company continues to have the right to
apply for removal from probation after two years from the effective date of the
consent order.

         On November 9, 1995, the Company received two Notices of Charge of
Discrimination from the United States Equal Employment Opportunity Commission
relating to two claimed violations of Title VII of the Civil Rights Act of 1964.
The first charge of employment discrimination was filed on October 31, 1995 by a
female employee of the Company and alleges sexual discrimination and harassment.
A second separate charge of discrimination was also filed on October 31, 1995,
by another female employee alleging sexual harassment against the same
individual named in the first charge of discrimination. On November 20, 1995,
the EEOC terminated its process with respect to the charges and issued Notices
of Right to Sue to the claimants. In February 1996, two lawsuits were filed in
the Eastern District of New York captioned Golovatskaya v. Halsey Drug Co., 96
CIV 0662 and Petrakova v. Halsey Drug Co., 96 CIV 0660 in connection with the
above charges. The lawsuits sought unspecified damages. These actions were
settled 

                                       15

<PAGE>   18
by the Company on September 26, 1997 and an aggregate payment of $12,400 made on
March 27, 1998 (approximately $5,200, in the case of Golovatskaya and
approximately $7,200, in the case of Petrakova).

CENCI PROCEEDING

         The Company was named as a defendant in a lawsuit in the United States
District Court for the Eastern District of California entitled Cenci v. Halsey
Drug Co. The claims in this lawsuit relate to a 1991 Stock Purchase Agreement
pursuant to which the Company purchased 51% of the stock of Cenci Labs and Cenci
Powder.

         The plaintiff, both individually and as a shareholder of Cenci Labs and
Cenci Powder, had sued the Company, one of the current officers and two former
officers of the Company. The complaint alleged that the Company had breached a
number of representations made during the course of the negotiations leading to
the stock purchase, including the representation that the Company would provide
financial assistance to both Cenci Labs and Cenci Powder. The complaint also
alleged misrepresentations relating to the scope of FDA's investigation of the
Company.

         The Complaint, which included several causes of action, sought
unspecified compensatory damages, as well as punitive damages, rescission,
specific performance, reformation and a declaration as to what amount, if any,
was owed to plaintiff. The counterclaims of the Company sought unspecified
compensatory and punitive damages.

         On March 10, 1997, a Settlement Agreement and Mutual Release was
executed by all parties to the lawsuit, terminating the action. The terms of the
Settlement provide for repayment of certain outstanding loan, made by the
plaintiff to Cenci Labs and Cenci Powders, as well as payment of settlement
funds, aggregating $600,000, to be paid in equal monthly installments, without
interest, from March 1997 to June 1998 and the delivery to the plaintiff of
25,000 shares of unregistered common stock of the Company. The Settlement
Agreement further provided for the balance of capital stock of Cenci Labs and
Cenci Powder to be conveyed to the Company, making Cenci Powder and Cenci Labs
100% and 97% owned subsidiaries, respectively, of the Company. Following with
the completion of the Offering, the Company satisfied its outstanding monetary
obligations to the plaintiff under the Cenci litigation in connection with the
execution of an Acknowledgment of Partial Satisfaction of Judgment by the
plaintiff. The Company, however, is obligated to remove the restrictions on the
25,000 shares of the Company's common stock previously tendered to the
plaintiff.

OTHER PENDING LEGAL PROCEEDINGS

         The Company was named as a defendant in an action captioned Allied
Welfare Fund, Vacation Fringe Benefit Fund and Union Mutual Fund v. Halsey Drug
Co., 96 Civ 3655, brought in the United States District Court for the Eastern
District of New York. The Complaint sought sums allegedly owed to three of the
Company's labor union funds under the Company's collective bargaining agreement,
in the amount of approximately $265,000. A settlement agreement was reached
between the parties and executed July 31, 1997 requiring the Company to remain
current on its obligations under its collective bargaining agreement and to pay
portions of the alleged arrearages in installments. Prior to the completion of
the Offering, the Company was in default under the settlement agreement. On
March 19, 1998, the Company satisfied its obligations under the settlement
agreement pursuant to the payment of $309,151 to the Union

                                       16

<PAGE>   19
         On March 4, 1992, an action was commenced against the Company and
numerous other pharmaceutical manufacturers in the Pennsylvania Court of Common
Pleas, Philadelphia Division, captioned Ciavarelli and Ciavarelli v. Abbott
Laboratories, Inc., et al. The Complaint contains seven causes of action,
including negligence, strict liability and breach of warranty, among others, in
connection with the alleged exposure of Ms. Ciavarelli to diethylstilbestrol
("DES"). The plaintiff was unable to determine which of the defendants produced
the DES used by Ms. Ciavarelli. The Complaint seeks in excess of $25,000 in
compensatory and punitive damages. This matter has been referred to the
Company's insurance carrier for defense, which has been assumed. Twenty
additional actions commenced during 1992 and 1993 are still pending against the
Company along with numerous other pharmaceutical manufacturers in the
Pennsylvania Court of Common Pleas, Philadelphia Division. Each of these actions
alleges injury in connection with exposure to DES and each seeks in excess of
$25,000 in compensatory and punitive damages. In each suit, the plaintiff was
unable to determine which of the defendants produced the DES that was used.
Numerous similar actions have already been settled and dismissed with nominal
contribution payments made by the Company.

         Two DES claims referred to the Company's insurance carriers are pending
in jurisdictions other than Pennsylvania.

         Each of the foregoing matters has been referred to the Company's
insurance carrier for defense. The Company does not believe any of such actions
will have a material impact on the Company's financial condition.

         The Company has been named a defendant in an action captioned "Raymore
v. Halsey Drug Co., Inc. and Benito Amado" commenced in March, 1997 in the
Eastern District of New York, 97 CIV 3116. The complaint alleges sexual
misconduct and harassment against a named individual defendant and seeks
$1,000,000 in compensatory and punitive damages. This action is currently in
discovery. Various settlement offers have been exchanged, ranging between
$30,000 and $75,000. The Company does not believe that the ultimate outcome of
this proceeding will have a material adverse effect on the Company's financial
condition.

         The Company has been named as a defendant in four additional actions
which have been referred to the Company's insurance carrier and have been
accepted for defense. The first action, Alonzo v. Halsey Drug Co., Inc. and
K-Mart Corp., No. 64DOT-95111-CT-2736 (Indiana Superior Court, Porter County),
was commenced on November 7, 1995 and involves a claim for unspecified damages
relating to the alleged ingestion of "Doxycycline 100." The second action, Files
v. Halsey Drug Co., Index No. 198787/93 (New York Supreme Court, Suffolk
County), commenced on September 16, 1993, seeks $10,000,000 in damages for
wrongful death allegedly caused by the ingestion of Isoniazid. The action is
currently in discovery. The third and fourth actions, entitled Hunt v. Halsey
Drug Co., Inc., and McCray v. Halsey Drug Co., Inc. (New York State Supreme
Court, Kings County), were commenced on October 21, 1993 and seek the recovery
of $8,000,000 for alleged personal injuries suffered by two Well Fargo security
guards who responded to an alarm and were shot, resulting in the death of one
and the injury to the other. The Company has impleaded the former security
service used by the Company as a third-party defendant. These actions are
currently in discovery. At this early stage of the proceedings, the Company is
unable to predict with any degree of certainty the likely outcome of these
claims and whether they will have a material adverse effect on the Company's
financial condition. 

         In addition to the matter described above, prior to the completion of
the Offering, the Company was a defendant in actions brought by various parties,
including Merill New York Co., relating to printing 

                                       17

<PAGE>   20
services and expenses of approximately $164,000, Valley City Disposal, relating
to waste disposal services in the amount of approximately $105,000, Xerox Corp.,
relating to expenses under office machine contracts of approximately $58,000,
and Atlantic Properties Company, relating to outstanding rent, expenses and
penalties of approximately $400,000. As part of the completion of the Offering,
the Company was able to negotiate discounts on the amounts paid to such
creditors and has satisfied the outstanding liabilities and settle these
matters. See also "Item 2 - Properties."


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

         No matters were submitted to a vote of security holders during the
fourth quarter of 1997.



                                                                                

                                       18

<PAGE>   21

                                     PART II


ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY
         AND RELATED SECURITY HOLDER MATTERS.

         Market and Market Prices of Common Stock

         The Company's Common Stock is listed on the American Stock Exchange
(the "Exchange") under the symbol "HDG." Set forth below for the periods
indicated are the high and low sales prices for the Common Stock as reported on
the Exchange.



<TABLE>
<CAPTION>
Period                                                       High                      Low
<S>                                                        <C>                      <C>
1998 FISCAL YEAR
      First Quarter (through
     March 15, 1997)                                         3 5/8                    1 1/4
1997 FISCAL YEAR
     First Quarter                                             6                      4 3/8
     Second Quarter                                          5 1/8                   2 9/16
     Third Quarter                                          4 13/16                  2 5/16
     Fourth quarter                                         4 13/16                  1 5/16
1996 FISCAL YEAR
     First Quarter                                           7 3/4                      3
     Second Quarter                                          7 1/4                      4
     Third Quarter                                           5 7/8                      4
     Fourth Quarter                                          6 3/8                      4
</TABLE>


         Holders

         There were 873 holders of record of the Company's common stock on March
15, 1998. This number, however, does not reflect the ultimate number of
beneficial holders of the Company's common stock.

         Dividend Policy

         The payment of cash dividends from current earnings is subject to the
discretion of the Board of Directors and is dependent upon many factors,
including the Company's earnings, its capital needs and its general financial
condition. The terms of the Company's 5% convertible senior secured debentures
prohibit the Company from paying cash dividends. The Company does not intend to
pay any cash dividends in the foreseeable future.


                                       19

<PAGE>   22
         Private Offerings

         As described under the caption "Business - Recent Events," on March 10,
1998, the Company completed a private offering of 5% convertible senior secured
debentures in the principal amount of $20.8 million and warrants exercisable for
4,202,020 shares of the Company's common stock. The securities were offered
solely to and purchased solely by accredited investors as defined under Rule 501
of Regulation D promulgated under the Securities Act. The Company relied on
Section 4(2) of the Securities Act and Regulation D promulgated thereunder.
Reference is made to the Company's Form 8-K as filed with the Securities and
Exchange Commission on March 24, 1998 for a detailed description of the Offering
and the terms of the debentures and warrants. The Form 8-K is incorporated
herein by this reference and is attached to this Report as Exhibit 10.41.


ITEM 6.  SELECTED FINANCIAL DATA.

         The selected consolidated financial data presented on the following
pages for the years ended December 31, 1997, 1996, 1995, 1994 and 1993 are
derived from the Company's audited Consolidated Financial Statements. The
Consolidated Financial Statements as of December 31, 1997 and December 31, 1996,
and for each of the years in the three year period ended December 31, 1997, and
the report thereon, are included elsewhere herein. The selected financial
information as of and for the years ended December 31, 1994 and 1993 are derived
from the audited Consolidated Financial Statements of the Company not presented
herein.

         The information set forth below is qualified by reference to, and
should be read in conjunction with, the Consolidated Financial Statements and
related notes thereto included elsewhere in this Report and "Management's
Discussion and Analysis of Financial Condition and Results of Operations," (Item
7).



<TABLE>
<CAPTION>
                                                     Years ended December 31,
                                1997           1996            1995           1994          1993
                               -------       --------        --------        -------       -------
                                               (in thousands, except per share data)
OPERATING DATA:
<S>                            <C>           <C>             <C>             <C>           <C>    
 Net sales                     $ 9,088       $ 12,379        $ 20,225        $24,182       $36,024
Costs and expenses
     Cost of sales              15,407         16,826          18,097         21,584        28,848
     Research and
       development                 979          1,854             818            502         2,140
     Selling, general
       and
     administrative                630          7,486           6,098          7,128         8,976
</TABLE>


                                       20

<PAGE>   23

<TABLE>
<CAPTION>
                                                                Years ended December 31,
                                   1997               1996               1995               1994                  1993
                               ------------        -----------        -----------        -----------           -----------
                                               (in thousands, except per share data)
<S>                            <C>                   <C>                <C>                <C>                   <C>      
OPERATING DATA:

Provision for
  regulatory
settlement                             --                 --                 --                 --                   5,935
Interest expense                      1,144              1,708              1,307                735                   631
Loss(Gain) on sale of           
 assets                                 264             (1,000)            (2,288)              --                    --
Provision for
  stockholders'
   litigation settlement               --                 --                 --                 --                   3,000

Income (loss) before
provision for income
taxes, minority interest
and cumulative effect
of accounting change
                                    (15,014)           (14,495)            (3,807)            (5,767)              (13,326)(1)


Provision (benefit) for
income  taxes                          --                 --                  296               --                  (2,540)

Minority interest in net
loss (benefit) of
subsidiaries                           --                 --                 --                 --                     150

Cumulative effect of
accounting change                      --                 --                 --                 --                    (267)
                               ------------        -----------        -----------        -----------           -----------

Net income (loss)              $    (15,014)       $   (14,495)       ($    4,103)       $    (5,767)          $   (10,903)
                               ============        ===========        ===========        ===========           ===========
Net income (loss) per
shares                         $      (1.12)       $     (1.49)       $      (.52)       $      (.80)          $     (1.57)
                               ============        ===========        ===========        ===========           ===========
Weighted average
common and common
shares equivalents
outstanding                    $ 13,434,215          9,724,106          7,886,101          7,173,908             6,954,713
                               ============        ===========        ===========        ===========           ===========
</TABLE>



                                       21

<PAGE>   24



<TABLE>
<CAPTION>
                                                                    December 31,
BALANCE SHEET DATA:                    1997            1996            1995            1994            1993
                                     --------        --------        --------        --------        --------
                                                       (In thousands, except per share data)
<S>                                  <C>             <C>             <C>             <C>             <C>      
Working capital (deficiency)         ($24,705)       $(12,201)       $ (7,393)       $ (4,451)       $ (2,801)
Total assets                            7,667          11,982          18,862          19,276          24,674
Total liabilities                      27,523          19,063          20,402          19,924          20,755
Retained earnings (accumulated        (44,498)        (29,484)        (14,989)        (10,886)         (5,118)
deficit)
Stockholders' equity (deficit)        (19,856)         (7,081)         (1,540)           (468)          2,919
</TABLE>


(1)      After giving effect to charges to operations aggregating $5,935,000
         arising from, among other things, the Company's consent decree and plea
         agreement with the DOJ and a $3,000,000 provision in connection with
         the settlement of shareholder and derivative litigations.


ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS.

         Certain statements set forth under this caption constitute
"forward-looking statements" within the meaning of the Reform Act. See "Special
Note Regarding Forward-Looking Statements " on page 1 of this Report for
additional factors relating to such Statements.

General

         On December 19, 1996, the Company was released from the FDA Application
Integrity Program (the "AIP"), allowing the Company to submit ANDA applications
for FDA review for new products, as well as Supplements, for the first time
since October 1991. At or about the time of such release, the Company submitted
five new ANDAs to the FDA for it review. In addition, the Company had previously
submitted a new ANDA with respect to the Capsules. As described under Item 1.
Business - Recent Events, the Company received FDA approval for five ANDAs since
its release from the AIP in December 1996, has three ANDA applications pending
and anticipates the submission of eight additional ANDAs during the balance of
1998. No assurance can be given, however, that pending ANDAs will be approved or
that the Company will be successful in submitting its planned ANDAs or in
receiving FDA approval for those already filed or to be filed.

         Sales for the year ended December 31, 1997 were approximately
$9,088,000 as compared to sales of approximately $12,379,000 for 1996. The net
loss for the year ended December 31, 1997 was $15,014,000, or $1.12 per share,
as compared with the net loss of $14,495,000 or $1.49 per share for 1996.

         The reduction in sales for the year ended December 31, 1997 was
primarily attributable to the lack of sufficient working capital necessary to
purchase raw materials. Without adequate inventory, the Company was unable to
satisfy customer orders in a timely fashion.

         Depreciation and amortization was approximately $1,294,000 in 1997, as
compared to $1,906,000 in 1996.

                                       22

<PAGE>   25
         On March 10, 1998, the Company completed a private offering of 5%
convertible senior secured debentures in the principal amount of $20.8 million
and common stock purchase warrants exercisable for an aggregate of 4,202,020
shares of the Company's common stock (the "Offering"). The net proceeds to the
Company from the Offering was approximately $19.6 million. In addition to
providing the Company with approximately $3 million in working capital, the net
proceeds from the Offering have permitted the Company to, among other things,
retire its existing bank indebtedness in the amount of approximately $3 million,
provide the funds necessary to satisfy its outstanding Federal and state payroll
tax liabilities, satisfy accrued and unpaid rent at its Brooklyn facility,
satisfy a significant portion of the Company's other current liabilities and
accounts payable, as well as permit the purchase of raw materials in order to
produce finished goods for shipment and to develop a finished goods inventory.
See "Liquidity and Capital Resources" and "Item 1. Business - Recent
Developments."

Results of Operations

         The following chart reflects expenses, earnings, income, losses and
profits expressed as a percentage of net sales for the years 1997, 1996 and
1995.



<TABLE>
<CAPTION>
                                               Percentage of Net Sales            Percentage Change
                                                                                    Year-to-Year
                                                                                 Increase (Decrease)
                                               Year ended December                  Years ended
                                                                                    December 31,
                                       1997           1996         1995       1996 to 1997  1995 to 1996
                                       ----           ----         ----       ------------  ------------
<S>                                 <C>           <C>           <C>           <C>           <C>   
Net sales                              100%          100.0%        100.0%        (26.6)       (38.8)
Cost of Goods                          169.5         135.9          89.5          (8.47)       (7.0)
Gross Profit                           (69.5)        (35.9)         10.5          42.1       (309.0)
Research & Development                  10.8          15.0           4.0         (47.2)       126.7
Selling, general and
    administrative expense              69.4          60.5          30.0         (15.7)        22.8
(Loss) earnings from
operations                            (149.7)       (111.4)        (23.7)         (1.3)       187.9
Interest expense                        12.6          13.9           6.5         (33.0)        30.6
Other (income) expenses                 2.9           (8.2)        (11.3)       (126.4)       (56.3)

(Loss) earnings before income
taxes, minority interest              (165.2)       (117.1)        (18.9)          3.6        280.7

(Benefit) provision for income
taxes                                 --            --               1.5        --             (100)
                                                                   -----
</TABLE>





                                       23

<PAGE>   26

<TABLE>
<CAPTION>
                                              Percentage of Net Sales                       Percentage Change
                                                                                             Year-to-Year
                                                                                          Increase (Decrease)
                                               Year ended December                            Years ended
                                                                                              December 31,
                                         1997            1996           1995        1996 to 1997          1995 to 1996
                                         ----            ----           ----        -------------          ------------

<S>                                    <C>             <C>             <C>                <C>               <C>  
(Loss) earnings before
   minority interest                     (165.2)         (117.1)         (20.4)             3.6               253.3
Minority interest in net
    earnings (loss) of
subsidiaries                                -                -              -                -                  -

Net (loss) earnings                     (165.2%)         (117.1)%        (20.4)%           3.6%              253.3%
                                                         ========        =======           ====              ======
</TABLE>


Net Sales

         Net sales of $9,088,000 represents a decrease of $3,291,000 as compared
to net sales for the year ended December 31, 1996. The Decrease in 1997 is
primarily attributable to a lack of sufficient working capital necessary to
purchase raw materials. Without adequate inventory, the Company was unable to
satisfy customer orders in a timely fashion. The Company's net sales for the
year ended December 31, 1996 of $12,379,000 represents a decrease by $7,846,000
as compared to net sales for the year ended December 31, 1995. In 1995, the
Company's net sales decreased by $3,957,000 as compared to 1994. The decrease in
1996 is primarily attributable to the removal from the marketplace of four
products and the withdrawal of four ANDA's by the Company, pursuant to a
requirement by the FDA, as a pre-condition to release of the Company from the
AIP. The decrease in 1995 was primarily attributable to the sale of the Tablets
ANDA to Mallinckrodt.

Cost of Goods Sold

         For 1997 and 1996, cost of goods sold decreased by approximately
$2,782,000 and $1,272,000, respectively, as compared to 1995. These decreases
are attributable to the reduction in shipments of products. For 1995, cost of
goods sold decreased by approximately $3,487,000 as compared to 1994. The
decrease for 1995 is primarily attributable to the reduction in shipments of
tablet products due to the sale by the Company of the Tablets ANDA combined with
significant reductions in manufacturing costs of personnel and other expenses.
The Company's gross margin as a percentage of sales for the fiscal years ended
December 31,1997, 1996 and 1995 was (69.5%), (35.9%) and 10.54%, respectively.
Sales reductions, withdrawal of the ANDA of the Capsule product, unabsorbed
manufacturing costs and inventory write-off had a direct impact upon gross
margin during 1996.

Research & Development expenses

         For 1997, research and development expenses amounted to $978,000 as
compared to $1,854,000 in 1996. This decrease was a result of reductions in
personnel necessitated by the Company's liquidity crisis. 

                                       24

<PAGE>   27
For 1996, research & developments expenses amounted to $1,854,000 as compared to
$818,000 in 1995. This increase is attributable to the Company's effort to
actively introduce new products, and to reintroduce products previously
discontinued.

Selling, General and Administrative Expenses

         Selling, general and administrative expenses as a percentage of sales
for the fiscal years 1997, 1996 and 1995 were 69.4%, 60.5%, and 30.0%,
respectively. These expenses decreased by approximately $1,178,000 or 15.7%in
fiscal year 1997 as compared to 1996. The decrease was attributable to cost
saving measures effected by management during the 1996 year. These expenses
increased by approximately $1,388,000, or 22.8%, in fiscal year 1996, as
compared to 1995. This increase is attributable to additional legal expenses and
litigation settlements during the year, as well as consulting expenses for FDA
related matters.

Interest Expense

         Interest expense for 1997 decreased by $564,000 as compared to 1996 due
primarily to the conversion in the latter part of 1996 of $7,740,000 of
convertible debentures bearing interest at 10% into common stock. Interest
expense for 1996 increased by $401,000 as compared to 1995 as a result of a
higher level of borrowings due to the issuance of convertible subordinated
debentures, as well as fees payable to the Company's banks (see "Liquidity and
Capital Resources" below). Interest expense for 1995 increased by $572,000 as
compared to 1994 due to the issuance of the convertible subordinated debentures.

Provision for Income Taxes

         The Company had no tax (benefit) provision for 1997, 1996 and 1995
since the available loss carryback to prior years was completely utilized by the
net operating loss for 1993 carryback to the prior three years.

Net Loss

         For 1997 and 1996 the Company had net losses of $15,014,000 and
$14,495,000, respectively, as compared to a net loss of $4,103,000 for 1995.
These net losses are attributable to the reduction in sales not offset by a
comparable reduction in cost of goods sold, increased legal expenses, litigation
settlements during the year and, in 1997, expenses incurred in discontinuing
certain manufacturing operations.

Liquidity and Capital Resources

         At December 31, 1997, the Company had cash and cash equivalents of
$26,000 as compared to $118,000 at December 31, 1996. The Company had a working
capital deficit at December 31, 1997 of $24,705,000.

         On March 10, 1998, the Company completed the Offering to Galen Partners
III, L.P., Galen Partners International III, L.P., Galen Employee Fund III, L.P.
(collectively, "Galen") and each of the Purchasers (along with Galen,
collectively the "Galen Investor Group") listed on the signature page to a
certain Debenture and Warrant Purchase Agreement dated March 10, 1998 (the
"Purchase Agreement"). The net proceeds to the Company from the Offering, after
deduction of related Offering expenses, were approximately $19.6 million. The
securities issued in the Offering consisted of 5% convertible senior 

                                       25

<PAGE>   28
secured debentures (the "Debentures") and common stock purchase warrants (the
"Warrants") exercisable for an aggregate of 4,202,020 shares of the Company's
common stock. See "Item 1. Business - Recent Events" for a discussion of the
Debentures and Warrants. Reference is also made to the Company's Form 8-K as
filed with the Securities and Exchange Commission on March 24, 1998 for a more
detailed description of the Debentures and Warrants, which is hereby
incorporated by this reference and is attached as Exhibit 10.41 to this Report.

         The Offering net proceeds of approximately $19.6 million have been
allocated to satisfy a substantial portion of the Company's current liabilities
and accounts payable. Such liabilities include the full satisfaction of the
Company's Bank indebtedness and related fees of approximately $3 million,
payment to the landlord at the Company's Brooklyn facility, and satisfaction of
judgments and liens. Such repayments have allowed the Company to avoid a
threatened foreclosure sale by its former Banks of Houba' s Indiana facility,
which secured the bank indebtedness.

         In addition, pursuant to agreements reached with other large creditors
in anticipation of completing the Offering, including the Company's landlord and
the DOJ, the Company has been able to bring these creditors current and in
compliance with installment payment agreements providing favorable terms to the
Company. The Offering proceeds will allow the Company to satisfy its outstanding
state and Federal payroll tax obligations and meet current payroll tax
obligations. The Offering proceeds also will allow the Company to satisfy a
substantial portion of its extensive arrear accounts payable and to secure
discounts relating to such payments. Finally, the significant reduction of the
Company's current liabilities combined with the working capital derived from the
Offering proceeds, have resulted in the Company's independent certified public
accountants issuing a report on the Company's financial statements for the year
ended December 31, 1997 which does not contain an explanatory paragraph as to
the Company's ability to continue as a going concern, which going concern
qualification was included in such reports for fiscal 1996 and 1995.

         Prior to the completion of the Offering, the Company was in
negotiations with the DOJ to restructure the payment of the $2,500,000 fine that
had been levied under the Plea Agreement in order to address the Company's
failure to satisfy the $125,000 quarterly installments provided for under the
Plea Agreement. On March 30, 1998, the Company and the DOJ signed a Letter
Agreement serving to amend the Plea Agreement relating to the terms of the
Company's satisfaction of the fine assessed under the Plea Agreement.
Specifically, the Letter Agreement provides that the Company will satisfy the
remaining $2,150,000 of the fine through the payment of $25,000 on a monthly
basis commencing May 1, 1998, plus interest on such outstanding balance (at the
rate calculated pursuant to 28 U.S.C. Section 1961)(currently 5.319%). Such
payment schedule would result in the full satisfaction of the DOJ fine in
December, 2005. The Letter Agreement also provides certain restrictions on the
payment of salary or compensation to any individual in excess of $50,000 without
the written consent of the United States District Court for the District of
Maryland, subject to certain exceptions. In addition, the Letter Agreement
requires the prepayment of the outstanding fine to the extent of 25% of the
Company's after tax profit and 25% of the net proceeds received by the Company
on any sale of a capital asset for a sum in excess of $10,000. The terms of the
Letter Agreement are subject to the approval of the U.S. District Court for the
District of Maryland.

         During the period from May 1997 through July 1997, the Company borrowed
approximately $3 million from Mylan Laboratories, Inc. pursuant to five
unsecured, demand promissory notes. The advances made by Mylan Laboratories,
Inc. were part of a proposed investment by Mylan Laboratories, Inc. in the
Company, including the proposed purchase of the Company's Houba Indiana facility
as well as a partial tender offer for the Company's common stock. The Company
used the proceeds of these borrowings for working capital. The $3 million
indebtedness relating to such advances remains outstanding and the

                                       26

<PAGE>   29
Company anticipates negotiating with representatives of Mylan Laboratories, Inc.
in an attempt to structure repayment terms acceptable to the Company. While the
Company believes that repayment terms acceptable to each of the Company and
Mylan Laboratories, Inc. will be agreed upon, no assurance can be made that the
Company will be successful in restructuring this indebtedness on terms favorable
to the Company. Failure to extend the term over which this indebtedness will be
repaid or to permit satisfaction of all or a portion of the indebtedness through
delivery of product produced by the Company, may have an adverse effect on the
Company's operations and financial condition.

         During the period from late 1996 through early March 1998, the Company
borrowed an aggregate of approximately $1,100,000 from certain of the holders of
the Company's convertible subordinated debentures and common stock. These
borrowings, evidenced by promissory notes, are due and payable as to principal
on demand. Interest on these notes, at the rate of 10% per annum, is payable on
a quarterly basis. The Company utilized the proceeds of these borrowings for
working capital. Upon the completion of the Offering, the Company satisfied
$800,000 of such indebtedness from the net proceeds of the Offering. The
remaining $300,000 of such indebtedness has, by agreement with the holder of
such note, been extended for a term of one year.

         During fiscal 1997 and up to the completion of the Offering, the
Company had insufficient capital resources to meet both its current and
long-term obligations. As a result of inadequate working capital, a decline in
shipments of solid dosage products from the Company's Brooklyn plant following
the entry of the Consent Decree, and the lack of available borrowings under the
Company's then existing credit facility, the Company's liquidity position had
been materially adversely affected since June 30, 1993 and the Company's capital
resources had been severely limited. During this period, the Company actively
sought to reduce its operating costs at the Brooklyn plant, including reductions
in personnel. Significant liabilities, however, and the absence of adequate
working capital, impaired the Company's ability to purchase and process raw
materials for sale as finished goods and to satisfy current liabilities and meet
operating expenses.

         The net proceeds from the Offering has permitted the Company to satisfy
a significant portion of its current liabilities and accounts payable. In
addition, based on Management's belief as to the Company's ability to defer a
portion of the Company's remaining notes and accounts payable and certain other
assumptions, including the restructuring of the indebtedness to Mylan 
Laboratories, Inc., the Company believes that it has approximately 3 million in
cash available for working capital derived from the net proceeds of the 
Offering. The Company estimates that such working capital will permit the
Company to purchase needed raw materials and fund near term operating losses
for approximately three to six months. In order to supplement such working
capital, the Company is in the process of negotiating with a banking
institution to secure a $5 million line of credit. In addition, in accordance
with the terms of the Debenture and Warrant Purchase Agreement pursuant to
which the Offering was completed, the Company has granted the Galen Investor
Group an option to invest an additional $5 million in the Company at any time
within eighteen months from the date of the closing of the Offering in exchange
for Debentures and Warrants having terms identical to those issued in the
Offering (the "Galen Option"). Galen has expressed an indication of interest to
exercise the Galen Option in the event the Company is in need of additional
capital. No assurance can be given, however, that the Company will be
successful in securing the $5 million line of credit or that the Galen Option
will be exercised. In the event the Company is successful in securing the line
of credit or in the event the Galen Option is exercised, the Company believes
that it will have sufficient working capital to fund operations for at least
the next twelve months.                                                        



                                       27

<PAGE>   30
Capital Expenditures

         The Company's capital expenditures during 1997, 1996 and 1995 were
$49,000, $208,000, and $536,000, respectively. The decrease in capital
expenditures in 1997 as compared to prior years is attributable to the Company's
cash conservation measures implemented in 1995.


I
TEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

         See Index to Financial Statements after signature page.


ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE.

         Not Applicable.



                                       28

<PAGE>   31


                                    PART III


ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

         The information required by Item 10 will be included in the Company's
Proxy Statement for the 1998 Annual Meeting of Shareholders, which will be filed
within 120 days after the close of the Company's fiscal year ended December 31,
1997, and is hereby incorporated herein by reference to such Proxy Statement.


ITEM 11. EXECUTIVE COMPENSATION.

         The information required by Item 11 will be included in the Company's
Proxy Statement for the 1998 Annual Meeting of Shareholders, which will be filed
within 120 days after the close of the Company's fiscal year ended December 31,
1997, and is hereby incorporated herein by reference to such Proxy Statement.


ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The information required by Item 12 will be included in the Company's
Proxy Statement for the 1998 Annual Meeting of Shareholders, which will be filed
within 120 days after the close of the Company's fiscal year ended December 31,
1997, and is hereby incorporated herein by reference to such Proxy Statement.


ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         The information required by Item 13 will be included in the Company's
Proxy Statement for the 1998 Annual Meeting of Shareholders, which will be filed
within 120 days after the close of the Company's fiscal year ended December 31,
1997, and is hereby incorporated herein by reference to such Proxy Statement.



                                                                                

                                       29

<PAGE>   32

                                     PART IV


ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

         (a)      Financial Statements - See Index to Financial Statements.

         (b)      Reports on Form 8-K

                  None.

         (c)      Exhibits


Exhibit
Number   Document
- ------   --------

3.1      Certificate of Incorporation and amendments (incorporated by reference
         to Exhibit 3.1 to Amendment No. 2 to the Registrant's Registration
         Statement on Form S-18, File No. 2471-NY).

3.2      Restated Bylaws (incorporated by reference to Exhibit 3.1 to the
         Registrant's Quarterly Report on Form 10-Q for the quarter ended June
         30, 1993).

10.1     Credit Agreement, dated as of December 22, 1992, among the Registrant
         and The Chase Manhattan Bank, N.A. (incorporated by reference to
         Exhibit 10.1 to the Registrant's Annual Report on Form 10-K for the
         year ended December 3 1, 1992 (the "1992 Form 10-K")).

10.2     Amendment Two, dated as of January 12, 1994, to Credit Agreement among
         the Registrant and The Chase Manhattan Bank, N.A. , together with forms
         of Stock Warrant and Registration Rights Agreement (incorporated by
         reference to Exhibit 10.1. to the Registrant's Annual Report on Form
         10-K for the year ended December 31, 1993 (the "1993 Form 10-K")).

10.3     Amendment Three, dated as of May 31, 1994, to Credit Agreement among
         the Registrant and The Chase Manhattan Bank, N.A. (incorporated by
         reference to Exhibit 6(a) to the Registrant's Quarterly Report on Form
         10-Q for the quarter ended March 31, 1994).

10.4     Amendment Four, dated as of July 1994, to Credit Agreement among the
         Registrant and The Chase Manhattan Bank, N.A. (incorporated by
         reference to Exhibit 6(a) to the Registrant's Quarterly Report on Form
         10-Q for the quarter ended June 30, 1994)).

10.5     Amendment Five, dated as of March 21, 1995, to Credit Agreement among
         the Registrant and The Chase Manhattan Bank, N.A. (incorporated by
         reference to Exhibit 10.7 to the Registrant's Current Report on Form
         8-K dated March 21, 1995 (the "March 8-K")).

10.5(l)  Form of Warrants issued to The Bank of New York, The Chase Manhattan
         Bank, N.A. and the Israel Discount Bank (incorporated by reference to
         Exhibit 10.5(i) to the Registrant's Annual Report on Form 10-K for the
         year ended December 31, 1995 (the "1995 Form 10-K")).

                                       30

<PAGE>   33
Exhibit
Number   Document
- ------   --------

10.5(2)  Letter Agreement, dated July 10, 1995, among Halsey Drug Co.,Inc., The
         Chase Manhattan Bank, N.A., The Bank of New York and Israel Discount
         Bank of New York (incorporated by reference to Exhibit 6(a) to the
         Registrant's Quarterly Report on Form 10-Q for the quarter ended June
         30, 1995 (the "June 10-Q")).

10.5(3)  Letter Agreement, dated November 16, 1995, among Halsey Drug Co.,Inc.,
         The Chase Manhattan Bank, N.A., The Bank of New York and Israel
         Discount Bank of New York (incorporated by reference to Exhibit
         10.25(iv) to the 1995 10-K).

10.5(4)  Amendment 6, dated as of August 6, 1996, to Credit Agreement among
         Halsey Drug Co.,Inc., The Chase Manhattan Bank, N.A., The Bank of New
         York and Israel Discount Bank of New York (incorporated by reference to
         Exhibit 10.1 to Amendment No. 1 to the Registrant's Quarterly Report on
         Form 10-Q for the quarter ended June 30, 1996 (the "June 1996 10-Q)).

10.5(5)  Letter Agreement, dated March 25, 1997 among Halsey Drug Co., Inc., The
         Chase Manhattan Bank, as successor in interest to The Chase Manhattan
         Bank (National Association), The Bank of New York and Israel Discount
         Bank.

10.6     Agreement Regarding Release of Security Interests dated as of March 21,
         1995 by and among the Company, Mallinckrodt Chemical Acquisition, Inc.
         and The Chase Manhattan Bank, N.A.(incorporated by reference to Exhibit
         10.9 of the March 8-K).

10.7     Consulting Agreement dated as of September, 1993 between the Registrant
         and Joseph F. Limongelli (incorporated by reference to Exhibit 10.6 to
         the 1993 Form 10-K).

10.8     Employment Agreement, dated as of January 1, 1993, between the
         Registrant and Rosendo Ferran (incorporated by reference to Exhibit
         10.2 to the 1992 Form 10-K).

10.10(1) Halsey Drug Co., Inc. 1984 Stock Option Plan, as amended (incorporated
         by reference to Exhibit 10.3 to the 1992 Form 10-K).

10.10(2) Halsey Drug Co., Inc. 1995 Stock Option and Restricted Stock Purchase
         Plan (incorporated by reference to Exhibit 4.1 to the Registrant's
         Registration Statement on Form S-8, File No. 33- 98396).

10.10(3) Halsey Drug Co., Inc. Non-Employee Director Stock Option Plan.

10.11    Leases, effective February 13, 1989 and January 1, 1990, respectively,
         among the Registrant and Milton J. Ackerman, Sue Ackerman, Lee
         Hinderstein, Thelma Hinderstein and Marilyn Weiss (incorporated by
         reference to Exhibits 10.6 and 10.7, respectively, to the Registrant's
         Annual Report on Form 10-K for the year ended December 31, 1989).

10.12    Lease, effective as of April 15, 1988, among the Registrant and Milton
         J. Ackerman, Sue Ackerman, Lee Hinderstein, Thelma Hinderstein and
         Marilyn Weiss, and Rider thereto (incorporated by reference to Exhibit
         10.12 to the Registrant's Annual Report on Form 10-K for the year ended
         December 31, 1987).

                                       31

<PAGE>   34
Exhibit
Number   Document
- ------   --------

10.12(l) Lease, as of October 31, 1994, among Registrant and Milton J. Ackerman,
         Sue Ackerman, Lee Hinderstein, Thelma Hinderstein and Marilyn Weiss,
         together with Modification, Consolidation and Extension Agreement
         (incorporated by reference to Exhibit 10. 12(i) to the Registrant's
         Annual Report on Form 10-K for the year ended December 31, 1995).

10.13    Asset Purchase Agreement dated as of March 21, 1995 among Mallinckrodt
         Chemical Acquisition, Inc. ("Acquisition"), Mallinckrodt Chemical,
         Inc., as guarantor and the Registrant (incorporated by reference to
         Exhibit 10.1 to the March 8-K).

10.14    Toll Manufacturing Agreement for APAP/Oxycodone Tablets dated as of
         March 21, 1995 between Acquisition and the Registrant (incorporated by
         reference to Exhibit 10.2 to the March 8-K).

10.15    Capsule ANDA Option Agreement dated as of March 21, 1995 between
         Acquisition and the Registrant (incorporated by reference to Exhibit
         10.3 to the March 8-K).

10.16    Tablet ANDA Noncompetition Agreement dated as of March 21, 1995 between
         the Registrant and Acquisition (incorporated by reference to Exhibit
         10.4 to the March 8-K).

10.17    Subordinated Non-Negotiable Promissory Term Note in the amount of
         $1,200,00 dated March 21, 1995 issued by the Registrant to Acquisition
         (incorporated by reference to Exhibit 10.5 to the March 8-K).

10.18    Term Note Security Agreement dated as of March 21, 1995 among the
         Company, Houba, Inc. and Acquisition (incorporated by reference to
         Exhibit 10.6 to the March 8-K).

10.19    Amendment dated March 21, 1995 to Subordination Agreement dated as of
         July 21, 1994 between Mallinckrodt Chemical, Inc., Mallinckrodt
         Chemical Acquisition, Inc., the Registrant, The Chase Manhattan Bank
         (National Association), Israel Discount Bank of New York, The Bank of
         New York, and The Chase Manhattan Bank (National Association)
         (incorporated by reference to Exhibit 10.8 to the March 8-K).

10.20    Agreement dated as of March 30, 1995 between the Registrant and
         Zatpack, Inc. (incorporated by reference to Exhibit 10.10 to the March
         8-K).

10.21    Waiver and Termination Agreement dated as of March 30, 1995 between
         Zuellig Group, W.A., Inc. and Indiana Fine Chemicals Corporation
         (incorporated by reference to Exhibit 10.11 to the March 8-K).

10.22    Convertible Subordinated Note of the Registrant dated December 1, 1994
         issued to Zatpack, Inc. (incorporated by reference to Exhibit 10.12 to
         the March 8-K).

10.23    Agreement dated as of March 30, 1995 among the Registrant, Indiana Fine
         Chemicals Corporation, Zuellig Group, N.A., Inc., Houba Inc.,
         Zetapharm, Inc. and Zuellig Botanicals, Inc. (incorporated by reference
         to Exhibit 10.13 to the March 8-K).

10.24    Supply Agreement dated as of March 30, 1995 between Houba, Inc. and
         ZetaPharm, Inc. (incorporated by reference to Exhibit 10.14 to the
         March 8-K).

                                       32

<PAGE>   35
Exhibit
Number   Document
- ------   --------

10.25    Form of 10% Convertible Subordinated Debenture (incorporated by
         reference to Exhibit 6(a) to the June 10-Q).

10.26    Form of Redeemable Common Stock Purchase Warrant (incorporated by
         reference to Exhibit 6(a) to the June 10-Q).

10.27    Form of 10% Convertible Subordinated Debenture (incorporated by
         reference to Exhibit 4.1 to the Registrant's Current Report on Form 8-K
         dated December 4, 1995 (the "December 8- K")).

10.28    Form of Redeemable Common Stock Purchase Warrant (incorporated by
         reference to Exhibit 4.2 to the December 8-K).

10.29    Form of 10% Convertible Subordinated Debenture (incorporated by
         reference to Exhibit 99 to the June 1996 10-Q).

10.30    Form of Redeemable Common Stock Purchase Warrant (incorporated by
         reference to Exhibit 4.1 to Amendment No. 1 to the June 1996 10-Q).

10.31    Form of 5% Convertible Senior Secured Debenture (incorporated by
         reference to Exhibit 4.1 to the Registrant's Current Report on Form 8-K
         dated March 24, 1998 (the "March 1998 8- K")).

10.32    Form of Common Stock Purchase Warrant (incorporated by reference to
         Exhibit 4.2 to the March 1998 8-K).

10.33    Debenture and Warrant Purchase Agreement dated March 10, 1998, by and
         among the Registrant, Galen Partners III, L.P. and the other Purchasers
         listed on the Signature Page thereto (incorporated by reference to
         Exhibit 10.1 to the March 1998 8-K).

10.34    Form of General Security Agreement of Halsey Drug Co., Inc. dated March
         10, 1998 (incorporated by reference to Exhibit 10.2 to the March 1998
         8-K).

10.35    Form of Agreement of Guaranty of Subsidiaries of Halsey Drug Co., Inc.
         dated March 10, 1998 (incorporated by reference to Exhibit 10.3 to the
         March 1998 8-K).

10.36    Form of Guarantor General Security Agreement dated March 10, 1998
         (incorporated by reference to Exhibit 10.4 to the March 1998 8-K).

10.37    Stock Pledge Agreement dated March 10, 1998 by and between the
         Registrant and Galen Partners III, L.P., as agent (incorporated by
         reference to Exhibit 10.5 to the March 1998 8-K).

10.38    Form of Irrevocable Proxy Agreement (incorporated by reference to
         Exhibit 10.6 to the March 1998 8-K).

10.39    Agency Letter Agreement dated March 10, 1998 by and among the
         Purchasers a party to the Debenture and Warrant Purchase Agreement,
         dated March 10, 1998 (incorporated by reference to Exhibit 10.7 to the
         March 1998 8-K).

                                       33

<PAGE>   36
Exhibit
Number   Document
- ------   --------

10.40    Press Release of Registrant dated March 13, 1998 (incorporated by
         reference to Exhibit 99.1 to the March 1998 8-K).

10.41    Current Report on Form 8-K as filed by the Registrant with the
         Securities and Exchange Commission on March 24, 1998.

*10.42   Letter Agreement between the Registrant and the U. S. Department of
         Justice dated March 27, 1998 relating to the restructuring of the fine
         assessed by the Department of Justice under the Plea Agreement dated
         June 21, 1993.

*10.43   Employment Agreement dated as of March 10, 1998 between the Registrant
         and Michael K. Reicher

*10.44   Employment Agreement dated as of March 10, 1998 between the Registrant
         and Peter Clemens 21 Subsidiaries of the Registrant (incorporated by
         reference to Exhibit 22 to the 1993 Form 10-K).

*23.1    Consent of Grant Thornton LLP, independent certified public
         accountants.

*27      Financial Data Schedule, which is submitted electronically to the
         Securities and Exchange Commission for informational purposes only and
         not filed.

- -----------------
*  Filed herewith.

                                                                                

                                       34

<PAGE>   37

                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

                                 HALSEY DRUG CO., INC.


                                 By   /s/ Michael Reicher
                                      --------------------------------------
                                          Michael Reicher, President and
                                          Chief Executive Officer (Principal
                                           Executive Officer)

                                 Date: April 13, 1998

         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.


<TABLE>
<S>                             <C>                                            <C> 
/s/ William G. Skelly           Chairman and Director                           April 13, 1998
- ----------------------
William G. Skelly

/s/ Michael Reicher             President, Chief Executive Officer              April 13, 1998
- --------------------
Michael Reicher                 and Director (Principal Executive
                                     Officer)

/s/ Peter Clemens               Vice President and Chief Financial              April 13, 1998
- ---------------------
Peter Clemens                   Officer (Principal Financial and
                                Accounting Officer)

- ---------------------           Director                                        April __, 1998
Alan J. Smith

/s/ Bruce F. Wesson
- ---------------------           Director                                        April 13, 1998
Bruce F. Wesson

/s/ William Sumner              Director                                        April 13, 1998
- ---------------------
William Sumner

/s/ Srini Conjeevaram           Director                                        April 13, 1998
- ---------------------
Srini Conjeevaram
</TABLE>




                                       35

<PAGE>   38

                          INDEX TO FINANCIAL STATEMENTS



<TABLE>
<CAPTION>
                                                                  Page
                                                                  ----
<S>                                                              <C>
Report of Independent Certified Public Accountants                F-2

Consolidated Balance Sheets                                       F-3

Consolidated Statements of Operations                             F-5

Consolidated Statement of Stockholders' Equity                    F-6

Consolidated Statements of Cash Flows                             F-9

Notes to Consolidated Financial Statements                        F-11 - F-40
</TABLE>


<PAGE>   39
                         REPORT OF INDEPENDENT CERTIFIED
                               PUBLIC ACCOUNTANTS



Board of Directors
    HALSEY DRUG CO., INC.


We have audited the accompanying consolidated balance sheets of Halsey Drug Co.,
Inc. and Subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Halsey Drug Co.,
Inc. and Subsidiaries as of December 31, 1997 and 1996, and the consolidated
results of their operations and their consolidated cash flows for each of the
three years in the period ended December 31, 1997, in conformity with generally
accepted accounting principles.





GRANT THORNTON LLP

New York, New York
April 14, 1998


                                      F-2

<PAGE>   40
                     Halsey Drug Co., Inc. and Subsidiaries

                           CONSOLIDATED BALANCE SHEETS

                                  December 31,
                                 (in thousands)




<TABLE>
<CAPTION>
                                                              1997             1996
                                                              ----             ----
<S>                                                         <C>              <C>
CURRENT ASSETS
    Cash                                                    $    26          $   118
    Accounts receivable - trade, net of allowances
       for doubtful accounts of $542 and $424
       in 1997 and 1996, respectively                            62              226
    Other receivable                                                           1,000
    Inventories                                               2,456            3,758
    Prepaid insurance and other current assets                  274              252
                                                            -------          -------
         Total current assets                                 2,818            5,354

         PROPERTY, PLANT AND EQUIPMENT, NET                   4,630            6,222

         OTHER ASSETS                                           219              406
                                                            -------          -------

                                                            $ 7,667          $11,982
                                                            =======          =======
</TABLE>


The accompanying notes are an integral part of these statements.

                                      F-3

<PAGE>   41
                     Halsey Drug Co., Inc. and Subsidiaries

                     CONSOLIDATED BALANCE SHEETS (CONTINUED)

                                  December 31,
                                 (in thousands)




<TABLE>
<CAPTION>
                                                                  1997               1996
                                                                  ----               ----
<S>                                                             <C>                <C>
CURRENT LIABILITIES
    Bank overdraft                                              $    159           $    286
    Due to banks                                                   2,476              3,195
    Notes payable                                                  4,825              1,625

    Convertible subordinated debentures                            2,244              2,173
    Department of Justice settlement                                 200              2,168
    Accounts payable                                               6,086              4,533
    Accrued expenses                                               7,644              3,575
    Deferred gain                                                  1,900
                                                                --------           --------
         Total current liabilities                                25,534             17,555

         LONG-TERM DEBT                                                               1,508

         DEPARTMENT OF JUSTICE SETTLEMENT                          1,990

         COMMITMENTS AND CONTINGENCIES

         STOCKHOLDERS' EQUITY (DEFICIT)
    Common stock - $.01 par value; authorized,
       20,000,000 shares; issued and outstanding,
       14,029,718 shares and 13,175,708 shares
       in 1997 and 1996, respectively                                140                131
    Additional paid-in capital                                    25,489             23,316
    Accumulated deficit                                          (44,497)           (29,484)
                                                                --------           --------
                                                                 (18,868)            (6,037)
    Less treasury stock - at cost ( 439,603 shares and
    474,603 shares in 1997 and 1996, respectively)                  (989)            (1,044)
                                                                --------           --------
                                                                  (19,857)            (7,081)
                                                                --------           --------

                                                                $  7,667           $ 11,982
                                                                ========           ========
</TABLE>


    The accompanying notes are an integral part of these statements.

                                      F-4

<PAGE>   42
                     Halsey Drug Co., Inc. and Subsidiaries

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                             Year ended December 31,
                      (in thousands, except per share data)







<TABLE>
<CAPTION>
                                                                  1997               1996                1995
                                                                  ----               ----                ----
<S>                                                             <C>                <C>                <C>
Net sales                                                       $  9,088           $ 12,379           $ 20,225
Cost of goods sold                                                15,406             16,826             18,097
                                                                --------           --------           --------

         Gross profit                                             (6,318)            (4,447)             2,128

         Research and development                                    979              1,854                818
         Selling, general and administrative expenses              6,308              7,486              6,098
                                                                --------           --------           --------

         Loss from operations                                    (13,605)           (13,787)            (4,788)

         Interest expense                                         (1,144)            (1,708)            (1,307)
         Other income (expense)                                     (264)             1,000              2,288
                                                                --------           --------           --------

         Loss before income taxes                                (15,013)           (14,495)            (3,807)

         Provision for income taxes                                                                        296
                                                                --------           --------           --------

         NET LOSS                                               $(15,013)          $(14,495)          $ (4,103)
                                                                ========           ========           ========

         Basic loss per common share                            $  (1.12)          $  (1.49)          $   (.52)
                                                                ========           ========           ========

         Weighted average number of outstanding shares            13,434              9,724              7,886
                                                                ========           ========           ========
</TABLE>


The accompanying notes are an integral part of these statements.

                                      F-5

<PAGE>   43
                     Halsey Drug Co., Inc. and Subsidiaries

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

                  Years ended December 31, 1997, 1996 and 1995
                                 (in thousands)







<TABLE>
<CAPTION>
                                             Common stock,                                         Treasury stock,
                                            $.01 par value        Additional                           at cost
                                           -----------------        paid-in      Accumulated     ------------------
                                           Shares     Amount        capital        deficit       Shares      Amount        Total
                                           ------     ------        -------        -------       ------      ------        -----
<S>                                       <C>        <C>         <C>            <C>              <C>        <C>          <C>
Balance at January 1,1995                  7,610       $76         $10,162        $(10,886)                              $  (648)

Issuance of common stock                     500         5             791                                                   796
Issuance of common stock in
   connection with litigation
   settlement                                825         8           2,992                                                 3,000
Repurchase of common stock                                                                      (500,000)   $ (1,100)     (1,100)
Issuance of warrants with convertible
   subordinated debentures                                             416                                                   416
Exercise of stock options                     39         1              98                                                    99
Net loss for the year ended 
   December 31, 1996                                                (4,103)                                               (4,103)
                                           -----       ---         -------        --------      --------    --------     -------
Balance at December 31, 1995
   (carried forward)                       8,974        90          14,459         (14,989)     (500,000)     (1,100)     (1,540)
</TABLE>


                                       F-6

<PAGE>   44
                     Halsey Drug Co., Inc. and Subsidiaries

           CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (CONTINUED)

                  Years ended December 31, 1997, 1996 and 1995
                                 (in thousands)







<TABLE>
<CAPTION>
                                              Common stock,                                      Treasury stock,
                                             $.01 par value      Additional                          at cost
                                             ---------------       paid-in     Accumulated      ------------------
                                             Shares   Amount       capital       deficit        Shares      Amount        Total
                                             ------   ------       -------       -------        ------      ------        -----
<S>                                         <C>       <C>        <C>           <C>             <C>         <C>         <C>
Balance at December 31, 1995
    (brought forward)                         8,974    $ 90       $ 14,459      $(14,989)      (500,000)   $ (1,100)   $ (1,540)

Issuance of common stock
    conversion of debentures                  3,504      35          6,724                                                6,759
Issuance of shares as settlement                 60                    262                       25,397          56         318
Issuance of warrants with convertible
    subordinated debentures                                            355                                                  355
Exercise of warrants of convertible
    debentures                                  589       6          1,363                                                1,369
Stock options exercised                          49                    153                                                  153
Net loss for the year ended
    December 31, 1996                                                            (14,495)                               (14,495)
                                             ------    ----       --------      --------        -------    --------    --------
Balance at December 31, 1996
    (carried forward)                        13,176     131         23,316       (29,484)      (474,603)     (1,044)     (7,081)
</TABLE>


                                       F-7

<PAGE>   45
                     Halsey Drug Co., Inc. and Subsidiaries

           CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (CONTINUED)

                  Years ended December 31, 1997, 1996 and 1995
                                 (in thousands)






<TABLE>
<CAPTION>
                                              Common stock,                                        Treasury stock,
                                             $.01 par value         Additional                         at cost
                                           ------------------        paid-in      Accumulated    -------------------
                                           Shares      Amount        capital        deficit      Shares       Amount        Total
                                           ------      ------        -------        -------      ------       ------        -----
<S>                                        <C>        <C>           <C>           <C>           <C>          <C>          <C>
Balance at December 31, 1996
   (brought forward)                       13,176     $    131       $ 23,316      $(29,484)    (474,603)    $ (1,044)    $ (7,081)

Issuance of common stock -
   conversion of debentures                   643            7          1,529                                                1,536
Issuance of shares as payment of
   interest                                    69            1            224                                                  225
Sale of treasury stock                         25                          45                     35,000           55          100
Exercise of warrants of convertible
   debentures                                  22                          72                                                   72
Stock options exercised                        95            1            303                                                  304
Net loss for the year ended
   December 31, 1997                                                                (15,013)                               (15,013)
                                         --------     --------       --------      --------     --------     --------     --------
   Balance at December 31, 1997            14,030     $    140       $ 25,489      $(44,497)     439,603     $   (989)    $(19,857)
                                         ========     ========       ========      ========     ========     ========     ========
</TABLE>


The accompanying notes are an integral part of this statement.

                                       F-8

<PAGE>   46
                     Halsey Drug Co., Inc. and Subsidiaries

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                             Year ended December 31,
                                 (in thousands)






<TABLE>
<CAPTION>
                                                                 1997             1996              1995
                                                                 ----             ----              ----
<S>                                                            <C>              <C>              <C>
Cash flows from operating activities
    Net loss                                                   $(15,013)        $(14,495)        $ (4,103)
                                                               --------         --------         --------
    Adjustments to reconcile net loss to net
      cash used in operating activities
         Depreciation and amortization                            1,733            1,906            1,956
         Provision for losses on accounts receivable                118              144
         Provision for loss on investment                                            500
         Gain on sale of assets                                      38           (1,000)          (2,288)
         Deferred income taxes                                                                        296
         Changes in assets and liabilities
             Accounts receivable                                     45            1,319              637
             Inventories                                          1,302            3,958             (881)
             Prepaid insurance and other current assets             165              (96)            (160)
             Accounts payable                                     1,851            1,029           (2,031)
             Accrued expenses                                     4,553            2,913              121
                                                               --------         --------         --------
         Total adjustments                                        9,805           10,673           (2,350)
                                                               --------         --------         --------
         Net cash used in operating activities                   (5,208)          (3,822)          (6,453)
                                                               --------         --------         --------
Cash flows from investing activities
    Capital expenditures                                            (85)            (390)            (536)
    Decrease (increase) in other assets                                                               116
    Net proceeds from sale of assets                                                                1,889
    Collection of notes receivable                               1,000
                                                               --------         --------         --------
         Net cash (used in) provided by investing
           activities                                               915             (390)           1,469
                                                               --------         --------         --------
</TABLE>


                                       F-9

<PAGE>   47
                     Halsey Drug Co., Inc. and Subsidiaries

                CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

                             Year ended December 31,
                                 (in thousands)



<TABLE>
<CAPTION>
                                                            1997            1996            1995
                                                            ----            ----            ----
<S>                                                       <C>             <C>             <C>
Cash flows from financing activities
    Increase (decrease) in notes payable                  $ 3,881         $    25         $(1,192)
    Proceeds from issuance of common stock                                    318             796
    Reissuance of treasury stock                               70
    Payments to Department of Justice                                                         (90)
    Bank overdraft                                           (127)             73              (5)
    Repurchase of common stock                                                             (1,100)
    Payments to minority stockholders                                        (206)           (212)
    Proceeds from issuance of convertible
      subordinated debentures                               4,600           2,500           7,740
    Proceeds from exercise of stock options                   305             153              99
    Proceeds from exercise of warrants                         72           1,369
    Increase in other assets                                                 (255)           (727)
                                                          -------         -------         -------
         Net cash provided by financing activities          4,201           3,977           5,309
                                                          -------         -------         -------
         NET (DECREASE) INCREASE IN CASH
             AND CASH EQUIVALENTS                             (92)           (235)            325

Cash and cash equivalents at beginning of year                118             353              28
                                                          -------         -------         -------

Cash and cash equivalents at end of year                  $    26         $   118         $   353
                                                          =======         =======         =======
</TABLE>



Supplemental disclosures of noncash activities:

     Year ended December 31, 1997
     ----------------------------
     The Company issued 642,407 shares of common stock to Zatpack, Inc. as
     payment for an outstanding note payable in the amount of $1,536,000.

     The Company reissued 25,000 shares of treasury stock as payment for $30,000
     in consulting fees and the receipt of $70,000 in cash.

     The Company issued 25,000 shares of common stock as payment for $225,452 in
     accrued interest.

     The Company recorded the satisfaction of $1,400,000 of subordinated
     promissory notes, related accrued interest of $200,000 and accounts 
     payable of $300,000 due to Mallinckrodt, in lieu of Mallinckrodt
     paying $1,900,000 owed to the Company as described in Note E.


     Years ended December 31, 1996 and 1995
     --------------------------------------
     The issuance of 3,504,000 shares of the Company's common stock upon
     conversion of $6,759,000 of convertible subordinated debentures is
     included in common stock and additional paid-in capital.        

     The valuation of the warrants issued in 1996 and 1995, of $355,000 and
     $416,000, respectively, with convertible subordinated debentures is
     included in additional paid-in capital.

     The issuance in 1996 and 1995 of 59,550 and 824,742 shares of the
     Company's common stock is valued at $318,000 and $3,000,000, respectively,
     in connection with litigation settlements.



The accompanying notes are an integral part of these statements.

                                      F-10

<PAGE>   48
                     Halsey Drug Co., Inc. and Subsidiaries

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                        December 31, 1997, 1996 and 1995



NOTE A - SUMMARY OF ACCOUNTING POLICIES

     The Company, a New York-based corporation established in 1935, and its
     subsidiaries, are engaged in the manufacture, sale and distribution of
     generic drugs. The Company sells its generic drug products under its Halsey
     label and under private-label arrangements with drug store chains and drug
     wholesalers throughout the United States.

     A summary of the significant accounting policies consistently applied in
     the preparation of the accompanying consolidated financial statements
     follows.

     1.  Principles of Consolidation and Basis of Presentation

         The consolidated financial statements include 100% of the accounts of
         the Company and its wholly-owned subsidiaries, Blue Cross Products Co.,
         Inc., Houba, Inc., Halsey Pharmaceuticals, Inc., and Indiana Fine
         Chemicals Corporation, The Medi-Gum Corporation, H.R. Cenci
         Laboratories, Inc. (97% owned) and Cenci Powder Products, Inc. (100%
         owned). The Medi-Gum Corporation and Halsey Pharmaceuticals have not
         commenced operations. All material intercompany accounts and
         transactions have been eliminated.

     2.  Liquidity Matters

         As of December 31, 1997, the Company has a working capital deficiency
         of approximately $24,705,000, has an accumulated deficit of
         approximately $44,496,000 and has incurred a loss of approximately
         $15,013,000 for the year then ended. The Company was also not in
         compliance with its financial covenants pursuant to its banking
         agreement and its convertible subordinated debenture agreement.

         On March 10, 1998, the Company completed a private offering of
         securities consisting of 5% convertible senior secured debentures and
         common stock purchase warrants exercisable for an aggregate of
         4,202,020 shares of the Company's common stock. The net cash proceeds
         to the Company from the offering, after the deduction of related cash
         offering expenses, was approximately $19.6 million.

         The net proceeds of the offering have, in large part, been used to
         satisfy a substantial portion of the Company's past due liabilities
         and accounts payable. Such liabilities include the full satisfaction
         of the Company's bank indebtedness and related fees, payment to the
         landlord of the Brooklyn

                                      F-11

<PAGE>   49
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE A (CONTINUED)

         facility and satisfaction of outstanding judgments and liens. Such
         repayments have allowed the Company to avoid the threatened foreclosure
         sale by its banks of the Indiana facility securing such indebtedness.
         Additionally, the satisfaction of the bank indebtedness resulted in
         curing the Company's default with its subordinated debenture agreement.
         Further, pursuant to agreements reached with other large creditors in
         anticipation of the completion of the offering, including the Company's
         landlord and the Department of Justice ("DOJ"), the Company has been 
         able to bring these creditors current and will be in compliance with 
         installment payment agreements providing favorable terms to the 
         Company. Satisfaction of the Company's current obligations to its 
         landlord of the Brooklyn facility for accrued and unpaid rent, 
         penalties and expenses has allowed the Company to renegotiate its 
         lease and avoid eviction. The offering proceeds will also allow the 
         Company to satisfy its outstanding state and Federal payroll tax 
         obligations and meet current payroll tax obligations.

         After giving effect to the application of the net proceeds of the
         offering, and based on management's belief as to the Company's ability 
         to defer a portion of remaining notes and accounts payable and certain
         other assumptions, the Company believes it will have  approximately
         $3,000,000 of cash available for working capital. The Company has
         submitted Abbreviated New Drug Applications ("ANDA") for approval by
         the Food and Drug Administration ("FDA") (Note M) and believes that
         approval of such  ANDA, which remains uncertain, will result in
         generating increased revenues. The Company is also currently in
         discussions with a financial institution to secure a $5,000,000 line
         of credit to supplement its working capital position and could
         potentially secure an additional $5,000,000 of working capital in the
         event that an investor exercises an option to purchase additional
         securities pursuant to the private placement agreement. No assurance
         can be given, however, that such financing will be secured on
         acceptable terms, if at all, or that the investor's option will be
         exercised.                                  

     3.  Inventories

         Inventories are stated at the lower of cost or market; cost is
         determined using the first-in, first-out method.

     4.  Property, Plant and Equipment

         Property, plant and equipment are stated at cost less accumulated
         depreciation and amortization. Depreciation and amortization are
         provided for in amounts sufficient to relate the cost of

                                      F-12

<PAGE>   50
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE A (CONTINUED)

         depreciable assets to operations over their estimated service lives,
         principally on a straight-line basis. The estimated lives used in
         determining depreciation and amortization are:


<TABLE>
<CAPTION>
<S>                                                                 <C>
         Buildings                                                      25 years
         Machinery and equipment                                    5 - 10 years
         Leasehold improvements                                     5 - 10 years
</TABLE>



         Leasehold improvements are amortized over the lives of the respective
         leases or the service lives of the improvements, whichever is shorter.

     5.  Income Taxes

         The Company accounts for income taxes utilizing an asset liability
         method for financial accounting and reporting for income taxes. Under
         this method, deferred tax assets and liabilities are determined based
         on differences between financial reporting and tax bases of assets and
         liabilities and are measured using the enacted tax rates and laws that
         will be in effect when the differences are expected to reverse.

     6.  Statements of Cash Flows

         For purposes of the statements of cash flows, the Company considers all
         highly liquid debt instruments purchased with an original maturity of
         three months or less to be cash equivalents. The Company paid no income
         taxes for the years ended December 31, 1997 and 1996 and $201,000
         during the year ended 1995. In addition, the Company paid interest of
         approximately $1,113,000, $1,173,000, $786,000, respectively, for the
         years ended December 31, 1997, 1996 and 1995.

     7.  Use of Estimates in Consolidated Financial Statements

         In preparing consolidated financial statements in conformity with
         generally accepted accounting principles, management makes estimates
         and assumptions that affect the reported amounts of assets and
         liabilities and disclosure of contingent assets and liabilities at the
         date of the consolidated financial statements, as well as the reported
         amounts of revenues and expenses during the reporting period. Actual
         results could differ from those estimates.

                                      F-13

<PAGE>   51
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE A (CONTINUED)

     8.  Research and Development Costs

         All research and development costs, including payments related to
         licensing agreements on products under development and research
         consulting agreements are expensed when incurred.

     9.  Impairment of Long-Lived Assets

         The Company adopted Statement of Financial Accounting Standards No. 121
         ("SFAS No. 121"), "Accounting for the Impairment of Long-Lived Assets
         and for Long-Lived Assets to Be Disposed Of," during the year ended
         December 31, 1996. The statement requires that the Company recognize
         and measure impairment losses of long-lived assets and certain
         identifiable intangibles and value long-lived assets to be disposed of.

         The Company reviews long-lived assets and certain identifiable
         intangibles held and used for possible impairment whenever events or
         changes in circumstances indicate that the carrying amount of an asset
         may not be recoverable (Note I).

    10.  Stock-Based Compensation

         In 1996, the Company adopted Statement of Financial Accounting
         Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based
         Compensation," and continues to apply APB Opinion No. 25, "Accounting
         for Stock Issued to Employees," and related interpretations in
         accounting for its plans and does not recognize compensation expense
         for its stock-based compensation plans other than for restricted stock
         (Note K).

    11.  New Pronouncements

         Earnings (Loss) Per Share

         In 1997, the Company adopted Statement of Financial Accounting
         Standards No. 128 ("SFAS No. 128"), "Earnings Per Share," which
         requires public companies to present basic earnings per share and, if
         applicable, diluted earnings per share. All comparative periods have
         been restated in accordance with SFAS No. 128.

                                      F-14

<PAGE>   52
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE A (CONTINUED)

         The computation of basic loss per share of common stock is based upon
         the weighted average number of common shares outstanding during the
         period, plus (in periods in which they have a dilutive effect) the
         effect of common shares contingently issuable upon exercise of stock
         options and warrants. Diluted earnings per share is considered equal to
         basic earnings per share for all years presented as the effect of other
         potentially dilutive securities would be antidilutive.

         Reporting Comprehensive Income

         In June 1997, the Financial Accounting Standards Board ("FASB") issued
         Statement of Financial Accounting Standards No. 130 ("SFAS No. 130"),
         "Reporting Comprehensive Income," which is effective for the Company's
         year ending December 31, 1998. The statement addresses the reporting
         and displaying of comprehensive income and its components. Earnings per
         share will only be reported for net income and not for comprehensive
         income and its components. Adoption of SFAS No. 130 related to
         disclosure within the financial statements and is not expected to have
         a material effect on the Company's financial statements.

         Segment Information

         In June 1997, the FASB also issued Statement of Financial Accounting
         Standards No. 131 ("SFAS No. 131"), "Disclosure About Segments of an
         Enterprise and Related Information," which is effective for the
         Company's year ending December 31, 1998. The statement changes the way
         public companies report information about segments of their business in
         their financial statements and requires them to report selected segment
         information in their quarterly reports. Adoption of SFAS No. 131
         relates to disclosure within the financial statements and is not
         expected to have a material effect on the Company's financial
         statements.

    12.  Reclassifications

         Certain reclassifications have been made to the 1996 and 1995
         presentations to conform to the 1997 presentation.

                                      F-15

<PAGE>   53
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE B - FAIR VALUE OF FINANCIAL INSTRUMENTS

         Long-term and Short-term Debt and Convertible Subordinated Debentures

         The fair value of the Company's long-term and short-term debt and
         convertible subordinated debentures is estimated based upon the quoted
         market prices for the same or similar issues or on the current rates
         offered to the Company for debt of the same remaining maturities.

         The carrying amount and fair value of the above financial instruments
         are as follows:



<TABLE>
<CAPTION>
                                                                         December 31,
                                            -------------------------------------------------------------------------------
                                                        1997                                         1996
                                            -------------------------------                --------------------------------
                                            CARRYING             Fair value                Carrying              Fair value
                                            AMOUNT                 amount                  amount                    amount
                                            ------                 ------                  ------                    ------
                                                                           (in thousands)
<S>                                         <C>                  <C>                       <C>                   <C>
Long-term and short-term
    debt                                    $7,301                 $7,301                  $6,328                  $6,328
Convertible subordinated
    debentures                               2,244                  2,244                   2,173                   2,173
</TABLE>




NOTE C - INVENTORIES

     Inventories consist of the following:


<TABLE>
<CAPTION>
                                                        December 31,
                                               -------------------------------
                                                1997                     1996
                                               -------                  ------
                                                       (in thousands)
<S>                                            <C>                      <C>
Finished goods                                 $   789                  $2,121
Work-in-process                                    263                   1,018
Raw materials                                    1,404                     619
                                               -------                  ------

                                               $2,456                   $3,758
                                               ======                   ======
</TABLE>


                                      F-16

<PAGE>   54
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE D - PROPERTY, PLANT AND EQUIPMENT

         Property, plant and equipment are summarized as follows:



<TABLE>
<CAPTION>
                                                                       December 31,
                                                               ----------------------------
                                                               1997                    1996
                                                               ----                    ----
                                                                      (in thousands)
<S>                                                           <C>                    <C>
Machinery and equipment                                       $11,478                $11,641
Leasehold improvements                                          5,967                  5,973
Building                                                          997                    998
Land                                                              265                    265
                                                              -------                -------

                                                               18,707                 18,877
Less accumulated depreciation and amortization                 14,077                 12,655
                                                              -------                -------

                                                              $ 4,630                $ 6,222
                                                              =======                =======
</TABLE>



         Depreciation expense for the years ended December 31, 1997, 1996 and
         1995 was approximately $1,640,000, $1,562,000 and $1,576,000,
         respectively.


NOTE E - DEBT

         Due to Banks

         At December 31, 1997 and 1996, the Company had $2,476,000 and
         $3,195,000 outstanding, respectively, under a line of credit agreement
         with three participating banks for which the average borrowing rate on
         these outstanding amounts for the years then ended was 11.9% and 
         10.43%, respectively. Borrowings under the line were available for 
         working capital purposes based upon a percentage of the parent
         company's eligible accounts receivable and were collateralized by such
         accounts receivable. The agreement contained certain financial
         covenants, for which the Company was not in compliance at December 31,
         1997. During March 1998, the Company completely satisfied its bank
         indebtedness and terminated the line of credit agreement with the bank
         (see Note Q).

                                      F-17

<PAGE>   55
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE E (CONTINUED)

     Long-term Debt

     Borrowings under long-term debt are as follows:



<TABLE>
<CAPTION>
                                                                      December 31,
                                                             -----------------------------
                                                             1997                     1996
                                                             ----                     ----
                                                                    (in thousands)
<S>                                                         <C>                    <C>
Convertible subordinated promissory note (a)                                        $ 1,508
Subordinated promissory notes (b)                                                     1,400
Notes payable (c)                                           $ 4,825                     225
                                                            -------                 -------

                                                              4,825                   3,133

Less current maturities of long-term debt                    (4,825)                 (1,625)
                                                            -------                 -------

                                                            $  --                   $ 1,508
                                                            =======                 =======
</TABLE>



    (a)  Convertible Subordinated Promissory Note

         Pursuant to the Zatpack, Inc. ("Zatpack") agreement (Note N), the
         Company issued a convertible subordinated promissory note dated
         December 1, 1994, to Zatpack, for the cancellation of trade payables
         and advances by Zuellig Group N.A., Inc. ("Zuellig") to the Company's
         subsidiaries, in the amount of $1,292,000, bearing interest at 8% per
         annum, compounded annually, due December 1, 1997. The outstanding
         principal, plus all accrued and unpaid interest, $1,508,000 at December
         31, 1996, was convertible, at the option of Zatpack, into the Company's
         common stock at the rate of one share of common stock for every $2.50
         of principal and interest being converted (the $2.50 is subject to the
         antidilution provisions of the promissory note). In March 1997, the
         principal amount, with related accrued interest of $243,110 was
         converted into 642,407 shares of Common Stock at an adjusted conversion
         price of $2.39 per share, thereby cancelling the indebtedness.

    (b)  Subordinated Promissory Notes

         On March 21, 1995 (see Note I), the Company satisfied certain accounts
         payable by issuing a subordinated promissory note to Mallinckrodt
         Chemical Acquisition, Inc. ("Mallinckrodt") for $1,200,000, bearing
         interest at 8% per annum, with interest and principal payable at the
         earlier

                                      F-18

<PAGE>   56
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE E (CONTINUED)

          of: (i) receipt by Mallinckrodt of all necessary authorizations from
          the FDA or (ii) March 21, 1998. The note is collateralized by
          substantially all of the assets of the Company and is subordinated to
          future bank indebtedness of up to $8,000,000. The $1,200,000 note
          represents the deferral of payment by the Company of a portion of its
          trade accounts payable due to an affiliate of Mallinckrodt. On July
          14, 1995, the Company borrowed from and issued a $200,000 subordinated
          promissory note to Mallinckrodt, bearing interest at 8% per annum,
          with principal and interest payable June 30, 1996. The principal and
          interest is payable, at the option of Mallinckrodt, in the form of
          cash or a credit to the Company's accounts receivable due from
          Mallinckrodt on June 30, 1996. On September 21, 1997, pursuant to the
          agreement with Mallinckrodt, the Company recorded the satisfaction of
          the $1,200,000 note, the subordinated promissory note of $200,000,
          related accrued interest of $200,000 and accounts payable of $300,000
          due to Mallinckrodt in lieu of Mallinckrodt paying the remaining
          balance of $1,900,000 owed to the Company as described in Note I.

     (c)  Notes Payable

          During 1997, the Company borrowed from and issued to several debenture
          holders and shareholders, unsecured, demand promissory notes in the
          amount of $1,125,000, bearing interest at 12% per annum, with interest
          payable quarterly.

          In addition, during the second quarter of 1997, the Company received
          funds, in the amount of $3,000,000, from a proposed purchaser of the
          Company's Indiana facility. These funds were tendered during the due
          diligence period, as an unsecured advance against anticipated payment,
          for the proposed purchase transaction. The purchase transaction was
          not consummated and the advance was converted into five non
          collateralized promissory notes with maturity dates from May 1, 1998
          through June 18, 1998.

          During the fourth quarter of 1997, the Company received, from an
          investor of a proposed joint venture, funds in the amount of $500,000
          represented by a demand promissory note, bearing interest at 10% per
          annum, secured by the property of Houba. In addition, as part of a
          proposed financing agreement, the Company received $200,000 as a
          promissory note bearing interest at 8% per annum during the fourth
          quarter of 1997.



                                      F-19

<PAGE>   57
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE F - CONVERTIBLE SUBORDINATED DEBENTURES AND STOCK WARRANTS

     In connection with certain 1995 amendments to the line of credit agreement
     described in Note E, the Company issued stock warrants to the bank,
     expiring July 17, 2000, to purchase up to 699,696 shares of the Company's
     common stock at exercise prices ranging from $1.98 to $2.07 per share. The
     fair value of the warrants, $200,000, as determined by the Company's Board
     of Directors, was recorded by the Company in 1994 as additional paid-in
     capital and a discount to bank debt which was fully amortized through the
     maturity date, August 31, 1995.

     On July 18, 1995, the Company issued 408 units, at $10,000 per unit, in a
     private placement of its securities ("July Private Placement"). Each unit
     consists of: (i) a 10% convertible subordinated debenture due July 18, 2000
     in the principal amount of $10,000, interest payable quarterly, and
     convertible into shares of the Company's common stock at a conversion price
     of $2.00 per share, subject to antidilution provisions, and (ii) 750
     redeemable common stock purchase warrants ("warrants"). Each warrant
     entitles the holder to purchase one share of common stock for $2.00,
     subject to adjustment during the five-year period commencing July 18, 1995.
     The warrants were redeemable by the Company at a price of $.01 per warrant
     at any time commencing July 18, 1996, provided that at July 18, 1996, the
     fair market value of the Company's common stock equals or exceeds $2.00 per
     share for the 20 consecutive trading days ending on the third day prior to
     the notice of redemption to the holders of the warrant. The debentures were
     converted into 2,040,000 shares of common stock in August 1996.

     On November 29, 1995, the Company issued 366 units, at $10,000 per unit, in
     a private placement of its securities ("November Private Placement"). Each
     unit consists of (i) a 10% convertible subordinated debenture due November
     29, 2000 in the principal amount of $10,000, interest payable quarterly,
     and convertible into shares of the common stock, at a conversion price of
     $2.50 per share, subject to dilution, and (ii) 600 redeemable common stock
     purchase warrants. The terms and conditions of the warrants issued in
     connection with the November Private Placement are similar to those issued
     in the July Private Placement, except that the exercise price of the
     warrant pursuant to the November Private Placement is $2.50 per share.
     These debentures were converted into 1,464,000 shares of common stock in
     December 1996.

     The Company received net proceeds from the July and November Private
     Placements of $7,013,000, net of issuance costs of $727,000, and allocated
     the market value of the warrants, as determined by the Company's Board of
     Directors, $416,000, to additional paid-in capital with a corresponding


                                      F-20

<PAGE>   58
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE F (CONTINUED)

     adjustment to debt discount. The net proceeds from such issuances have been
     used for the following purposes: repurchase of 500,000 shares of the
     Company's common stock, registration of the underlying shares pursuant to
     the Private Placements, the purchase of equipment, research and development
     costs and for working capital. In addition, the Company was required to use
     $950,000 of the net proceeds to repay a portion of its outstanding bank
     debt during 1995.

     On August 6, 1996, the Company issued 250 units, at $10,000 per unit, in a
     private placement of its securities ("August Private Placement"). Each unit
     consists of: (i) a 10% convertible subordinated debenture due August 6,
     2001 in the principal amount of $10,000, interest payable quarterly, and
     convertible into shares of the Company's common stock at a conversion price
     of $3.25 per share, subject to dilution, and (ii) 750 redeemable common
     stock purchase warrants ("warrants"). Each warrant entitles the holder to
     purchase one share of common stock for $3.25, subject to adjustment during
     the five-year period commencing August 6, 1996. Pursuant to the agreement,
     the Company was required to establish an escrow account to repay interest
     in the outstanding convertible debenture, which was fully paid during 1997.
     The Company received net proceeds from this private offering of
     approximately $2,160,000. The Company was required to use $391,000 of said
     net proceeds to repay a portion of its bank debt, accrued interest and
     legal fees. The Company used the balance of the net proceeds of the
     Offering for: working capital; registration of the underlying shares under
     the Securities Act; purchase of equipment; and for research and development
     expenses.


NOTE G - ACCRUED EXPENSES

     Accrued expenses are summarized as follows:


<TABLE>
<CAPTION>
                                                                   December 31,
                                                                   ------------
                                                           1997                   1996
                                                           ----                   ----
                                                                  (in thousands)
<S>                                                      <C>                    <C>
            Payroll taxes payable (Note H)               $3,290                 $1,554
            Interest                                      1,018                    539
            Professional fees                               537                    227
            Accrued pension and welfare                     501                    185
            Medicaid rebates payable                        481                    169
            Accrued payroll                                 420                    441
            Accrued rent                                    412                    227
            Other                                           985                    233
                                                         ------                 ------

                                                         $7,644                 $3,575
                                                          =====                  =====
</TABLE>




                                      F-21

<PAGE>   59
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE G (CONTINUED)

     At December 31, 1997 payroll taxes payable included $2,900,000 of
     delinquent payroll taxes due to the Internal Revenue Service and New York
     State (Note Q).

     The payroll taxes payable at December 31, 1997 include approximately
     $2,400,000 and $499,000 of delinquent payroll taxes due to the Internal
     Revenue Service and the State of New York, respectively, all of which
     liability was incurred in 1997 and 1996. The Company has accrued interest
     and penalties of $364,000 and $205,000 on these Federal and State
     liabilities, respectively. The Company expects that the Federal liability
     will be partially offset by income tax refund claims which were filed. To
     date, the IRS has not taken action with respect to these refund claims
     pending the completion of an IRS audit for the year 1993. This audit was
     recently completed by the IRS auditor with no changes proposed. However
     completion is pending review within the IRS; therefore, the Company has not
     recorded tax refund claims.


NOTE H - INCOME TAXES

     The actual income tax expense varies from the Federal statutory rate
applied to consolidated operations as follows:


<TABLE>
<CAPTION>
                                                                       YEAR ENDED DECEMBER 31,
                                                                       -----------------------
                                                    1997                           1996                          1995
                                                    ----                           ----                          ----

                                             AMOUNT           %             AMOUNT          %            AMOUNT            %
                                             ------           -             ------          -            ------            -
                                                                             (IN THOUSANDS)

<S>                                         <C>            <C>            <C>            <C>             <C>           <C>
       Federal statutory rate               $(5,105)       (34.0)%        $(4,928)       (34.0)%         $(749)        (34.0)%
       Loss for which no tax benefit
          was provided                        4,924         32.8            4,233         29.1             280          12.7
       Losses of subsidiaries with
          no tax benefit                                                      424          3.0             240          10.9
       Amortization of Warrants                  24           .2               32           .2
       Goodwill amortization                     12           .1               73           .5              77           3.5
       Department of Justice
          settlement                                                           57           .4
       Other                                    145           .9              109           .8             152           6.9
                                            -------         ----          -------         ----          ------          ----

       Actual tax expense                   $    -             -    %     $     -            -   %      $   -              -   %
                                            ======          ====          =======         ====          ======          ====
</TABLE>





                                      F-22

<PAGE>   60
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE H (CONTINUED)

     The Company has net operating loss carryforwards aggregating approximately
     $28,890,000, expiring during the years 2009 through 2012. In addition,
     certain of the Company's subsidiaries filed separate Federal income tax
     returns in prior years and have separate net operating loss carryforwards
     aggregating approximately $5,297,000 expiring during the years 1998 through
     2012.

     The tax loss carryforwards of the Company and its subsidiaries are subject
     to limitation by Section 382 of the Internal Revenue Code with respect to
     the amount utilizable each year. This limitation reduces the Company's
     ability to utilize net operating loss carryforwards included above each
     year. The amount of the limitation has not been quantified by the Company.

     The components of the Company's deferred tax assets (liabilities), pursuant
     to SFAS No. 109, are summarized as follows:


<TABLE>
<CAPTION>
                                                          December 31,
                                                          ------------
                                                     1997            1996
                                                     ----            ----
                                                       (in thousands)
<S>                                              <C>              <C>
Deferred tax assets
   Net operating loss carryforwards                $ 15,115        $ 12,824
   Allowance for doubtful accounts                      304             178
   Research and development tax credit                  202             212
   Reserve for inventory                                886             605
   Litigation settlement                                195             284
   Rent                                                 172              96
   Reserve for Medicaid                                 209
   Capital loss carryforwards                           210             210
   Reserve for property, plant and equipment            111
   Other                                                 44              97
                                                   --------        --------
   Gross deferred tax assets                         17,448          14,506
                                                   --------        --------
Deferred tax liabilities
   Depreciation                                        (828)           (663)
   Installment sale gain                               (798)         (1,218)
   Other                                                (42)           (165)
                                                   --------        --------
                                                     (1,668)         (2,046)
                                                   --------        --------
      Net deferred tax assets before
         valuation allowance                         15,780          12,460
 Valuation allowance                                (15,780)        (12,460)
                                                   --------        --------
        Net deferred tax assets                    $   --          $     --
                                                   ========        ========
</TABLE>




                                      F-23

<PAGE>   61
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE H (CONTINUED)

     SFAS No. 109 requires a valuation allowance against deferred tax assets if,
     based on the weight of available evidence, it is more likely than not that
     some or all of the deferred tax assets may not be realized. The valuation
     allowance at December 31, 1996 primarily pertains to uncertainties with
     respect to future utilization of net operating loss carryforwards.


NOTE I - OTHER INCOME (EXPENSE)

     Cessation of California Operations

     During 1997, management decided to shut down its California operations
     which comprised two of its subsidiaries, Cenci Powder Products, Inc. and
     Cenci Laboratories, Inc. The Company had not incurred any significant costs
     to exit these operations other than minimal vacation compensation and
     salary paid to a former plant employee to manage the exit process.

     At December 31, 1997, the net assets of Cenci Laboratories, Inc., consisted
     primarily of building, equipment and land with a net carrying value of
     $528,000 and inventory with a total net carrying value of $93,000.
     Accordingly, during 1997 the Company recorded a charge of $264,000 to
     reduce the fixed assets to their estimated net realizable value, and a
     $93,000 charge to write off the remaining inventory. For the years ended
     December 31, 1997, 1996 and 1995, these subsidiaries, in aggregate,
     accounted for revenues of approximately $400,000, $290,000, and $446,000,
     respectively.

     During March 1998, the Company signed a letter of intent to sell
     substantially all of the non-real property assets of Cenci Powder Products,
     Inc., consisting primarily of $90,000 in inventory, to a
     purchaser/creditor, in exchange for the forgiveness of approximately
     $260,000 of the Company's indebtedness.



                                      F-24

<PAGE>   62
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE I (CONTINUED)

         Sale of Assets

         (a)      On March 21, 1995, the Company sold its Abbreviated New Drug
                  Application ("ANDA") for 5mg Oxycodone HCL/325mg Acetaminophen
                  Tablets ("Tablets") and certain equipment used in the
                  production of the Tablets for up to $5.4 million to
                  Mallinckrodt. The Company received $500,000 of the proceeds in
                  July 1994, which was recorded as deferred income on the
                  Company's 1994 consolidated balance sheet. Mallinckrodt also
                  paid the Company $2,000,000 on March 21, 1995 and the
                  remainder was to be payable as follows: (i) $1,000,000 upon
                  the Company receiving general clearance from the FDA for
                  unrestricted operations at its Brooklyn facility and written
                  notice from the FDA that it is in compliance with certain
                  provisions of the consent degree dated June 29, 1993 and (ii)
                  $1,900,000 at the earlier of (a) Mallinckrodt receiving
                  certain authorizations from the FDA or (b) March 21, 1998.
                  Mallinckrodt also agreed to defer $1,200,000 of the Company's
                  trade debt due to an affiliate of Mallinckrodt (Note E).
                  Pursuant to the release of the Company from the FDA's
                  Application Integrity Policy list and its Restrictions
                  (collectively, the "AIP") by the FDA on December 19, 1996, the
                  Company recorded a gain of $1,000,000. On January 9, 1997,
                  Mallinckrodt tendered this amount to the Bank Group. Pursuant
                  to the agreement of September 21, 1997, the Company recorded
                  $1,900,000 as a deferred gain which was recognized on March
                  21, 1998.

                  In connection with the agreement, the Company agreed to
                  manufacture Tablets for Mallinckrodt for a period of three
                  years and Mallinckrodt agreed to order a minimum number of
                  Tablets from the Company for two years ending March 21, 1997.
                  The Company and Mallinckrodt entered into a noncompetition
                  agreement pursuant to which the Company agreed not to compete
                  with Mallinckrodt and its affiliates with respect to the
                  Tablets until March 21, 2000.

                  In addition, the Company issued to Mallinckrodt an option to
                  purchase the ANDA for acetaminophen/oxycodone capsules at an
                  exercise price equal to 3/4 of annual net capsule revenue, as
                  defined. As of March 21, 1998, Mallincrodkt did not exercise
                  the option, which had lapsed at that time.



                                      F-25

<PAGE>   63
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE J - PENSION EXPENSE

    The Company maintains the following two pension plans:

     1.  Management Pension Plan

         The Company had maintained a defined benefit plan covering
         substantially all nonunion employees which was terminated in November
         1996. Subsequently, all Plan assets were converted to cash and held in
         a money market fund (to continue the Trust) from which all vested
         participant interests will be paid. Based on information provided by
         the Company's actuary, the total liability of the Plan as of the plan
         year ended November 30, 1997 was $398,281. The actuary has determined
         that this amount is sufficient to pay the vested interests of all of
         the participants who were in the Plan as of November 30, 1996, and for
         any participants who had terminated with previously vested interests
         that had not yet been paid. Included in the Plan's assets as of
         November 30, 1997, were receivables from the Company and the Insurer
         for $54,631 and $57,468, respectively, which were subsequently paid in
         March 1998. No additional contributions were required to be paid to the
         Trust for the period ended November 30, 1997.

         Pending certain approvals by the Pension Benefit Guarantee Corporation
         ("PBGC"), relating to plan termination, the plan Trustees will be able
         to make the distributions to the vested participants. The actuary
         anticipates these distributions during 1998. Prior to such
         distributions, any earnings realized on the Plan assets will be added
         to the vested participant's account proportionately. When all assets
         are distributed from the Trust, the Trust will terminate and a final
         filing will be made with the Internal Revenue Service.

         Historically, the Company's funding policy for the management pension
         plan (the "Plan"), had been to contribute amounts equal to its
         liability as determined under the Employee Retirement Income Security
         Act of 1974 ("ERISA"). Under this funding policy, contributions would
         be sufficient to maintain plan assets in excess of the projected
         benefit obligation. As of December 31, 1996, the Company has not funded
         its 1995 ERISA obligation of approximately $92,000 and the remaining
         balance of its 1993 and 1992 ERISA obligations of approximately
         $191,000. As a result of Company contributions during 1997, earnings on
         plan assets and terminations during 1997, the Company's previous
         outstanding obligations mentioned above had been satisfied.


                                      F-26

<PAGE>   64
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE J (CONTINUED)

         Net pension cost for the Company-sponsored pension plan consists of the
following:


<TABLE>
<CAPTION>
                                            December 31,
                                            ------------
                                    1997         1996       1995
                                    ----         ----       ----
                                            (in thousands)

<S>                                 <C>         <C>         <C>
Normal service cost                 $           $ 24        $ 49
Interest cost                         31          32          25
Actual return on plan assets         (23)        (23)        (19)
Net amortization and deferral         (8)         (8)         (9)
                                    ----        ----        ----

     Net pension cost               $--         $ 25        $ 46
                                    ====        ====        ====
</TABLE>



         The reconciliation of the funded status of the plan to the amount
         reported in the Company's balance sheet is as follows:


<TABLE>
<CAPTION>
                                                         Year ended December 31,
                                                         -----------------------
                                                            1997         1996
                                                            ----         ----
                                                             (in thousands)
<S>                                                        <C>          <C>
Actuarial present value of benefit obligations
    at November 30, 1996 and 1995
       Estimated present value of vested benefits          $ 398        $ 440
       Estimated present value of nonvested benefits                       52
                                                           -----        -----

       Accumulated benefit obligation                        398          492
       Value of future pay increases                                       12
                                                           -----        -----

       Projected benefit obligation                          398          504

Estimated market value of plan assets
   at November 30, 1997 and 1996                             398          569
                                                           -----        -----

        Excess (deficiency) of plan assets
           over projected benefit obligation                               65

Unrecognized net (gain) loss                                 (15)         (72)
Unrecognized net asset at December 1,
    1987 being amortized over 24 years                        (8)          (8)
                                                           -----        -----

                                                             (23)       $ (15)
                                                           =====        =====
</TABLE>





                                      F-27

<PAGE>   65
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE J (CONTINUED)

         The assumptions used as of November 30, 1997 and 1996 in determining
         pension expense and funded status shown above were as follows:


<TABLE>
<CAPTION>
                                            1997            1996
                                            ----            ----
<S>                                         <C>            <C>
Discount rate                               7.00%          7.00%
Rate of salary progression                     0%          4.00
Long-term rate of return on assets          7.00           7.00
</TABLE>



     2.  Employees' Pension Plan

         The Company contributed approximately $407,000, $492,000 and $450,000
         in 1997, 1996 and 1995 respectively, to a multiemployer pension plan
         for employees covered by collective bargaining agreements. This plan is
         not administered by the Company and contributions are determined in
         accordance with provisions of negotiated labor contracts. Information
         with respect to the Company's proportionate share of the excess, if
         any, of the actuarially computed value of vested benefits over the
         total of the pension plan's net assets is not available from the plan's
         administrator.

         The Multiemployer Pension Plan Amendments Act of 1980 (the "Act")
         significantly increased the pension responsibilities of participating
         employers. Under the provision of the Act, if the plans terminate or
         the Company withdraws, the Company could be subject to a "withdrawal
         liability."


NOTE K - STOCK OPTION PLAN

     In September 1995, the stockholders of the Company approved the adoption of
     a stock option and restricted stock purchase plan (the "1995 Option Plan").
     The 1995 Option Plan replaces its existing stock option plan which expired
     in January 1994. The 1995 Option Plan provides for the granting of (i)
     nonqualified options to purchase the Company's common stock at not less
     than the fair market value on the date of the option grant, (ii) incentive
     stock options to purchase the Company's


                                      F-28

<PAGE>   66
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE K (CONTINUED)

     common stock at not less than the fair market value on the date of the
     option grant and (iii) rights to purchase the Company's common stock on a
     "Restricted Stock" basis, as defined, at not less than the fair market
     value on the date the right is granted. The total number of shares which
     may be sold pursuant to options and rights granted under the 1995 Option
     Plan is 1,000,000. No option can be granted under the 1995 Option Plan
     after May 2005 and no option can be outstanding for more than ten years
     after its grant.

     In October 1996, the Board of Directors of Company adopted a non-employee
     director stock option plan which provides for the granting of nonqualified
     stock options not to exceed 100,000 shares in total and at an exercise
     price per share equal to the fair market value of a share or the respective
     grant dates. No option can be granted under the plan or after October 16,
     2006 and no option can be outstanding for more than ten years after its
     grant. No options have been granted under this plan to date.

     The Company has adopted the disclosure provisions of Statement of Financial
     Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based
     Compensation." It applies APB Opinion No. 25, "Accounting for Stock Issued
     to Employees," and related interpretations in accounting for its plans and
     does not recognize compensation expense for its stock-based compensation
     plans other than for restricted stock. If the Company had elected to
     recognize compensation expense based upon the fair value at the grant date
     for awards under these plans consistent with the methodology prescribed by
     SFAS No. 123, the Company's net income and earnings per share would be
     reduced to the pro forma amounts indicated below:


<TABLE>
<CAPTION>
                                                                                   Year ended December 31,
                                                                                   -----------------------
                                                                        1997                 1996                 1995
                                                                        ----                 ----                 ----
                                                                            (thousands, except per share amounts)
<S>                                                                   <C>                 <C>                   <C>
        Net loss
            As reported                                               $15,013             $(14,495)             $(4,103)
            Pro forma                                                  15,328              (14,180)              (4,459)
        Loss per share
            As reported                                                $(1.12)              $(1.49)               $(.52)
            Pro forma                                                   (1.14)               (1.46)                (.56)
</TABLE>






                                      F-29

<PAGE>   67
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE K (CONTINUED)

     These pro forma amounts may not be representative of future disclosures
     because they do not take into effect pro forma compensation expenses
     related to grants made before 1995. The fair value of these options was
     estimated at the date of grant using the Black-Scholes option-pricing model
     with the following weighted average assumptions for the years ended
     December 31, 1997, 1996 and 1995, respectively: expected volatility of 82%,
     82% and 71%; risk-free interest rates of 6.6%, 6.6% and 5.8%; and expected
     lives of 4 years, 4.6 years and 8.8 years. At the date of grant, all
     exercise prices equaled the market value of the stock.

     The Black-Scholes option valuation model was developed for use in
     estimating the fair value of traded options which have no vesting
     restrictions and are fully transferable. In addition, option valuation
     models require the input of highly subjective assumptions including the
     expected stock price volatility. Because the Company's employee stock
     options have characteristics significantly different from those of traded
     options, and because changes in the subjective input assumptions can
     materially affect the fair market estimate, in management's opinion, the
     existing models do not necessarily provide a reliable single measure of the
     fair value of its employee stock options.

     Transactions involving stock options are summarized as follows:


<TABLE>
<CAPTION>
                                                                   Weighted
                                                      Stock        average
                                                      options      exercise
                                                    outstanding     price
                                                    -----------     -----

<S>                                                 <C>            <C>

Balance at January 1, 1995                            222,150         3.98

Granted                                               471,600         3.16
Exercised                                             (39,180)        2.50
Cancelled                                             (54,070)        3.36
                                                     --------
Balance at December 31, 1995 (carried forward)        600,500         3.49
</TABLE>






                                      F-30

<PAGE>   68
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE K (CONTINUED)


<TABLE>
<CAPTION>
                                                                                                              Weighted
                                                                                      Stock                    average
                                                                                      options                 exercise
                                                                                    outstanding                 price
                                                                                    -----------                 -----
<S>                                                                                 <C>                     <C>
        Balance at December 31, 1995 (brought forward)                                 600,500                 $3.49

        Granted                                                                        126,000                  4.77
        Exercised                                                                      (49,159)                 3.12
        Cancelled                                                                      (21,334)                 4.39
                                                                                     ---------

        Balance at December 31, 1996                                                   656,007                  3.53

        Exercised                                                                      (89,300)                 3.22
        Cancelled                                                                      (84,968)                 5.16
                                                                                     ---------

        Balance at December 31, 1997                                                   481,739                  3.60
                                                                                      ========
</TABLE>



     The following table summarizes information concerning currently outstanding
and exercisable stock options:


<TABLE>
<CAPTION>
                                                      Options outstanding                         Options exercisable
                                    -----------------------------------------------        ------------------------------
                                                           Weighted
                                       Number               average        Weighted            Number           Weighted
                                    outstanding at         remaining        average        exercisable at        average
                Ranges of           December 31,          contractual      exercise         December 31,        exercise
             exercise prices            1997                 life            price              1997              price
             ---------------        -------------         -----------     -----------      --------------      --------
<S>           <C>                   <C>                    <C>              <C>             <C>                <C>
              $1.90 -  $4.00          363,572                7.69             $3.13           363,572            $3.13
               4.01 -   5.00           95,667                8.53              4.79            14,667             4.34
               5.01 -   6.25           22,500                4.37              6.17            19,500             6.15
                                      -------                                                 -------
                                      481,739                                                 397,739
                                      =======                                                 =======
</TABLE>





                                      F-31

<PAGE>   69
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE L - COMMITMENTS

     The Company occupies plant and office facilities under noncancellable
     operating leases which expired in December 1995. The Company entered into a
     new operating lease for the plant and office facilities covering the period
     from January 1, 1996 to December 31, 2005. These new operating leases
     provide for scheduled base rent increases over the term of the lease,
     however, the total amount of the base rent payments will be charged to
     operations using the straight-line method over the term of the lease. The
     leases provide for payment of real estate taxes based upon a percentage of
     the annual increase. The Company's subsidiaries, H.R. Cenci Laboratories,
     Inc. and Cenci Powder Products, Inc., lease plant and office facilities on
     a month-to-month basis from a former officer of the subsidiaries. Rent
     expense relating to these leases amounted to approximately $90,000, $90,000
     and $86,000 in 1997, 1996 and 1995, respectively. In addition, the Company
     rents certain equipment under operating leases, generally for terms of four
     years. Total rent expense for the years ended December 31, 1997, 1996 and
     1995 was approximately $1,243,000, $884,000 and $659,000, respectively.

     The approximate minimum rental commitments under these operating leases are
as follows:


<TABLE>
<CAPTION>
                     Twelve months ending December 31,                            (in thousands)
<S>                                                                                <C>
                         1998                                                         $   975
                         1999                                                           1,023
                         2000                                                           1,075
                         2001                                                           1,128
                         2002                                                           1,186
                         2003 and thereafter                                            3,921
                                                                                        -----

                            Total minimum payments required                            $9,308
                                                                                       ======
</TABLE>


NOTE M - CONTINGENCIES

     The Company currently is a defendant in several lawsuits involving product
     liability and other claims. The Company's insurance carriers have assumed
     the defense for all product liability and other actions involving the
     Company. None of the lawsuits is brought as a class action. The ultimate
     outcome of these lawsuits cannot be determined at this time, and
     accordingly, no adjustment has been made to the consolidated financial
     statements.


                                      F-32

<PAGE>   70
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE M (CONTINUED)

     On October 23, 1996, the Company withdrew four of its ANDAs including its
     ANDA for acetaminophen/oxycodone capsules (the "Capsule ANDA"), and halted
     sales of the affected products. Net sales pursuant to the withdrawn Capsule
     ANDA were approximately $3 million and $8 million for the years ended
     December 31, 1996 and 1995, respectively, and accounted for approximately
     24% and 50% of the Company's total net sales during such twelve-month
     periods (Note P). There were no related sales during 1997. The Company
     instituted the withdrawal at the suggestion of the FDA and in anticipation
     of its release from the FDA's AIP. The FDA had placed the Company on the
     AIP, in October 1991, in connection with its investigation of the Company's
     operations which culminated in the 1993 consent decree. Under the AIP, the
     FDA suspended all of the parent company's (i.e., Halsey Drug Co.'s)
     applications for new drug approvals, including ANDAs and supplements to
     ANDAs. At the FDA's suggestion, the Company retained outside consultants to
     perform validity assessments of its drug applications. Thereafter, in
     October 1996, the FDA recommended that several applications, including the
     Capsule ANDA, be withdrawn. As a basis of its decision, the FDA cited
     questionable and incomplete data submitted in connection with the
     applications. The FDA indicated that withdrawal of the four ANDAs was
     necessary for the release of the Company from the AIP. The FDA further
     required submission by the Company of a Corrective Action Plan. Said Plan
     was prepared and submitted by the Company and accepted by the FDA during
     1997.

     On December 19, 1996, the FDA released the Company from the AIP. As a
     consequence, for the first time since October 1991, the Company was
     permitted to submit ANDAs to the FDA for review. Since its release from the
     AIP in December 1996, through the fiscal year ended December 31, 1997, the
     Company submitted six ANDAs for review by the FDA, including a new ANDA
     with respect to the Capsules. During the period from the Company's release
     from the AIP to March 15, 1998, the Company received five ANDA approvals,
     all of which relate to ANDA filings made with the FDA subsequent to the
     Company's release from the AIP.



                                      F-33

<PAGE>   71
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE M (CONTINUED)

     As of March 15, 1998, the Company had submitted two additional ANDAs for
     review by the FDA in fiscal 1998 and anticipates the submission of eight
     additional ANDAs during the balance of fiscal 1998. Although the Company
     has been successful in receiving the ANDA approvals described above since
     its release from the AIP in December 1996, there can be no assurance that
     any of its newly submitted ANDAs, or those contemplated to be submitted,
     will be approved by the FDA. The Company will not be permitted to market
     any new product unless and until the FDA approves the ANDA relating to such
     product. Failure to obtain FDA approval for the Company's pending ANDAs, or
     a significant delay in obtaining such approval, would adversely affect the
     Company's business operations and financial condition.

     On June 21, 1993, the Company entered into a Plea Agreement with the DOJ to
     resolve the DOJ's investigation into the manufacturing and record keeping
     practices of the Company's Brooklyn plant. Under the terms of the Plea
     Agreement, the Company agreed to plead guilty to five counts of
     adulteration of drug products shipped in interstate commerce. Each count
     involved product adulteration, and record keeping deficiencies relating to
     a single drug product, Quinidine Gluconate (324mg tablets), manufactured at
     the Brooklyn plant. The Plea Agreement also required the Company to pay a
     fine of $2,500,000 over five years in quarterly installments of $125,000,
     commencing on or about September 15, 1993. The Company's plea was entered
     and the terms of the Plea Agreement were approved by the United States
     District Court for the District of Maryland on July 13, 1993. As of
     February 28, 1998, the Company was in default of the payment terms of the
     Plea Agreement and had made payments aggregating $350,000. On March 27,
     1998, the Company and the DOJ signed the Letter Agreement serving to amend
     the Plea Agreement relating to the terms of the Company's satisfaction of
     the fine assessed under the Plea Agreement. Specifically, the Letter
     Agreement provides that the Company will satisfy the remaining $2,150,000
     of the fine through the payment of $25,000 on a monthly basis commencing
     May 1, 1998, plus interest on such outstanding balance (at the rate
     calculated pursuant to 28 U.S.C Section 1961)(currently 5.319%). Such
     payment schedule will result in the full satisfaction of the DOJ fine in
     December, 2005. The Letter Agreement also provides certain restrictions on
     the payment of salary or compensation to any individual in excess of
     $150,000 without the written consent of the United States District Court
     for the District of Maryland, subject to certain exceptions. In addition,
     the Letter Agreement requires the repayment of the outstanding fine to the
     extent of 25% of the Company's after tax profit or the remaining balance
     owed and 25% of the net proceeds received by the Company on any sale of a
     capital asset for a sum in excess of $10,000. If, at any time, the Company
     does not make the payments required under the Letter Agreement in a timely
     fashion, the United States will be free to declare that the fine is
     delinquent and/or in default, and exercise all legal process to immediately
     collect the full amount of the fine, interest and applicable penalties.


                                      F-34

<PAGE>   72
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE M (CONTINUED)

     In connection with several shareholder lawsuits, the Company agreed to pay
     to the plaintiffs $1,000,000 in cash, which has been paid by the Company's
     insurance carrier in full. In November 1995, the Company satisfied the
     remainder of its settlement obligation by issuing 824,742 shares of its
     common stock valued at $3,000,000 or $3.6375 per share.

     On January 29, 1997, the Securities and Exchange Commission ("SEC")
     simultaneously instituted and settled an administrative proceeding against
     the Company, pursuant to the Company's Offer of Settlement, dated September
     13, 1996, as modified by letters dated October 11, 1996 and January 10,
     1997. The Order made the following findings, among others, which the
     Company neither admitted nor denied. The Company's December 31, 1990 and
     December 31, 1991 Annual Reports on Form 10-K stated that the Company had
     to follow current Good Manufacturing Practices ("CGMP") regulations at all
     times during which an FDA-approved drug was manufactured by the Company.
     These annual reports further stated that the Company had to "expend time,
     money and effort in the areas of production and quality control to ensure
     full technical compliance." These annual reports failed to disclose that
     the Company was not manufacturing drugs in accordance with CGMP, but was
     using unapproved formulas and procedures, and the Company's employees, at
     former management's direction, were concealing product adulteration from
     the FDA. These annual reports also failed to disclose that, since the
     Company was not manufacturing generic drugs in accordance with CGMP, FDA
     approval for any or all of the Company's new products could be adversely
     affected. Based on the foregoing, the Commission found that the Company
     committed violations of Sections 10(b) and 13(a) of the Exchange Act and
     Rules 10b-5, 12b-20 and 13a-1 thereunder, by filing with the Commission
     Annual Reports on Form 10-K for the years ended December 31, 1990 and 1991
     that omitted to state material facts necessary to make the statements made,
     in the light of the circumstances under which they were made, not
     misleading. The Order also requires the Company to "cease and desist from
     committing or causing any violation and any future violation" of Sections
     10-(b) and 13(a) of the Exchange Act and Rules 10b-5, 12b-20 and 13a-1
     thereunder.

     In 1995, the SEC filed a complaint requiring the Company to cease and
     desist from violating Section 17(a) of the Securities Act and Sections
     10(b) and 13(a) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and
     13a-13 thereunder. The complaint alleged that the Company's December 31,
     1990 and December 31, 1991 Annual Reports on Form 10-K and March 31, 1991,
     June 30, 1991, September 30, 1991, March 31, 1992, June 30, 1992 and
     September 30, 1992 quarterly reports on


                                      F-35

<PAGE>   73
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE M (CONTINUED)

     Form 10-Q were materially false and misleading. The SEC complaint conforms
     in large part to a settlement proposal previously submitted by the Company.
     The Company, without admitting the allegations, entered into a Consent
     Decree not to violate the law in the future.

     By letter dated October 23, 1995, the Company was notified by the New York
     State Education Department (the "Department") that the Professional Conduct
     Officer of the Office of Professional Discipline had determined that there
     was sufficient evidence of professional misconduct on the Company's part to
     warrant a disciplinary proceeding pursuant to New York law. Upon contacting
     the Deputy Director of the Office of Professional Discipline, counsel for
     the Company was advised that the alleged misconduct related to the same
     activities that were the subject of the DOJ investigation, indictment and
     plea. The Company submitted a written response on November 16, 1995. The
     Company and the Department have agreed to the entry of a Consent Order
     concluding any disciplinary proceedings. The Company will pay $175,000 in
     fines over five years. In addition, the Company's registration as a
     manufacturer of drugs in New York State is revoked, but such revocation is
     stayed and the Company has been placed on probation for a maximum of five
     years. The Company has the right to apply for removal from probation after
     two years.

     A lawsuit was filed by the minority shareholders of H.R. Cenci
     Laboratories, Inc. and Cenci Powder Products, Inc. against the Company and
     several of the officers of the Company. The lawsuit alleged that the
     Company has breached several representations made during the course of
     negotiations leading to the Company's purchase of 51% of the stock of H.R.
     Cenci Laboratories, Inc. This action sought unspecified compensatory
     damages, as well as punitive damages, rescission, specific performance,
     reformation and a declaration as to what amount, if any, was owed to
     plaintiff. The Company filed a Counterclaim, seeking unspecified
     compensatory and punitive damages. On March 10, 1997, a Settlement
     Agreement and Mutual Release was executed by all parties to the lawsuit,
     terminating the action. The terms of the Settlement provide for repayment
     of certain outstanding loans, made by the plaintiff to Cenci Labs and Cenci
     Powders, as well as payment of settlement funds. These payments total
     $600,000, payable in equal monthly installments from March, 1997 to June,
     1998. The Settlement Agreement further provided for the balance of Cenci
     Labs and Cenci Powder stock to be turned over to the Company. Twenty-five
     thousand shares of unregistered Common Stock of the Company was issued to
     the plaintiff. (Following the completion of the private offering (Note A),
     the Company satisfied its outstanding monetary obligations to the plaintiff
     under the Cenci litigation in connection with the execution of an
     Acknowledgement of Partial Satisfaction of Judgment by the plaintiff.)



                                      F-36

<PAGE>   74
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE M (CONTINUED)

     The Company was named as a defendant in an action captioned Allied Welfare
     Fund, Vacation Fringe Benefit Fund and Union Mutual Fund v. Halsey Drug
     Co., 96 Civ 3655, brought in the United States District Court for the
     Eastern District of New York. The complaint seeks sums allegedly owed to
     three of the Company's labor union funds under the Company's collective
     bargaining agreement, in the amount of approximately $265,000. A settlement
     agreement was reached between the parties and executed July 31, 1997
     requiring the Company to remain current on its obligations under its
     collective bargaining agreement and to pay portions of the alleged
     arrearages in installments. Prior to the completion of the Offering, the
     Company was in default under the settlement agreement. On March 19, 1998,
     the Company satisfied its obligations under the settlement agreement
     pursuant to the payment of $309,151 to the Unions.


NOTE N - SALE OF COMMON STOCK

     On March 30, 1995, the Company entered into an agreement with Zatpack which
     provides for the purchase of 500,000 shares of common stock of the Company
     by Zatpack, with registration rights, in consideration of $1,000,000. The
     $1,000,000 consideration consists of the cancellation of indebtedness
     (incurred by the Company's subsidiaries for the purchase of raw materials
     delivered from affiliates of Zuellig) and shares of Indiana Fine Chemicals
     Corporation. As a result of the above transaction, the Company owns 100% of
     Indiana Fine Chemical Corporation (prior to the above transaction, the
     Company owned 70% of Indiana Fine Chemical Corporation). In addition, the
     Company issued a convertible promissory note to Zatpack, dated December 1,
     1994 (Note E). Zatpack has acquired the above assets from Zuellig and its
     subsidiaries.

     On October 27, 1994, the Company sold 500,000 shares of its common stock in
     exchange for $1,000,000 from Ranbaxy Pharmaceuticals, Inc. ("Ranbaxy"). In
     connection with these shares, Ranbaxy had the right to have its shares of
     the Company's common stock registered under the Securities Act of 1933. In
     July 1995, the Company repurchased the 500,000 shares from Ranbaxy for
     $1,100,000.



                                      F-37

<PAGE>   75
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE O - SIGNIFICANT CUSTOMERS AND SUPPLIERS

     The Company sells its products to a large number of customers who are
     primarily drug distributors, drugstore chains and wholesalers and are not
     concentrated in any specific region. The Company performs ongoing credit
     evaluations of its customers and generally does not require collateral.
     During 1997, the Company had net sales to two customers in excess of 10% of
     total sales, aggregating 32.1% of total sales. During 1996, the Company had
     net sales to one customer aggregating 10% of total sales. During 1995, the
     Company had net sales to two customers aggregating 25% and 11% of total
     sales, respectively.


NOTE P - FOURTH QUARTER ADJUSTMENTS

     During the fourth quarter of 1997, the Company recorded a provision to
     write down approximately $1,300,000 of inventory to its net realizable
     value.

     Additionally, during the fourth quarter of 1997, the Company accrued
     approximately $650,000 in connection with penalties and/or interest on
     delinquent rent and payroll taxes. Subsequent to year-end, these amounts
     were substantially paid or incorporated into a repayment schedule with the
     related creditor.


NOTE Q - SUBSEQUENT EVENTS

     Private Placement

     As described in Note A, effective March 10, 1998 the Company consummated a
     private offering of securities, simultaneously with a Debenture and
     Warrant Purchase agreement with multiple investors, in exchange for an
     aggregate purchase price of $20,800,000. Net proceeds of this financing
     approximating $19,700,000, along with related non-cash issuance costs, will
     be recorded during the first quarter of 1998. The securities consisted
     of 5% convertible senior secured debentures and common stock purchase
     warrants exercisable for 4,202,020 shares of the Company's common stock.
     The debentures mature on March 15, 2003 with interest payable on a
     quarterly basis. Also, in accordance with certain "as converted" terms of
     the purchase agreement, one investor, will likely obtain voting rights
     enabling it to control approximately 50% of the Company's common stock.



                                      F-38

<PAGE>   76
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE Q (CONTINUED)

     With respect to the 4,202,020 warrants, 2,101,010 warrants were granted to
     purchase common shares with a par value of $.01 at an exercise price of
     $1.50 with the remaining 2,101,010 warrants being granted to purchase
     common shares with a par value of $.01 at an exercise price of $2.375.
     Additionally, the debentures may be converted at any time after issuance 
     into common shares at a price of $1.50 per share or in accordance
     with other terms of the purchase agreement. 

     The net proceeds from this offering have been allocated to satisfy a
     substantial portion of the Company's current liabilities and accounts
     payable (approximately $7,333,000) which include: (i) the complete
     satisfaction of the Company's bank debt and related fees approximating
     $3,000,000 and (ii) an obligation to a landlord and satisfaction of
     related judgments and liens. Further, pursuant to repayment agreements
     reached with other large creditors in anticipation of the completed
     offering creditors (including the Department of Justice as described in
     Note M ), the Company has been able to bring these creditors current and
     potentially comply with terms for future repayment. Such terms include (i)
     payment to Internal Revenue Service of approximately $2,000,000 for
     delinquent Federal payroll taxes and interest in April 1998 (ii) payment
     to New York State of $375,000 for delinquent payroll taxes in March 1998
     and (iii) an installment payment program with the Department of Justice
     which provides for, among other things, the payment of penalties and
     interest totaling $2,150,000 to be made in monthly installments of $25,000
     commencing in May 1998 through December 2005.


                                      F-39

<PAGE>   77
                     Halsey Drug Co., Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                        December 31, 1997, 1996 and 1995



NOTE Q (CONTINUED)

     Employment Contracts

     During March 1998, the Company entered into employment contracts with each
     of two new officers/employees of the Company which cover a five-year and
     three-year period, respectively. The contracts provide for, among other
     things: (i) annual salaries of $170,000 and $140,000 to be paid over the
     five-year and three-year periods, respectively and (ii) an aggregate of
     1,300,000 options to purchase the Company's stock at an exercise price of
     $2.38 per common share that vest evenly over a three to five year service
     period and expire in ten years.



                                      F-40

<PAGE>   78

 
                               Index to Exhibits

Exhibit
Number   Document
- ------   --------

3.1      Certificate of Incorporation and amendments (incorporated by reference
         to Exhibit 3.1 to Amendment No. 2 to the Registrant's Registration
         Statement on Form S-18, File No. 2471-NY).

3.2      Restated Bylaws (incorporated by reference to Exhibit 3.1 to the
         Registrant's Quarterly Report on Form 10-Q for the quarter ended June
         30, 1993).

10.1     Credit Agreement, dated as of December 22, 1992, among the Registrant
         and The Chase Manhattan Bank, N.A. (incorporated by reference to
         Exhibit 10.1 to the Registrant's Annual Report on Form 10-K for the
         year ended December 3 1, 1992 (the "1992 Form 10-K")).

10.2     Amendment Two, dated as of January 12, 1994, to Credit Agreement among
         the Registrant and The Chase Manhattan Bank, N.A. , together with forms
         of Stock Warrant and Registration Rights Agreement (incorporated by
         reference to Exhibit 10.1. to the Registrant's Annual Report on Form
         10-K for the year ended December 31, 1993 (the "1993 Form 10-K")).

10.3     Amendment Three, dated as of May 31, 1994, to Credit Agreement among
         the Registrant and The Chase Manhattan Bank, N.A. (incorporated by
         reference to Exhibit 6(a) to the Registrant's Quarterly Report on Form
         10-Q for the quarter ended March 31, 1994).

10.4     Amendment Four, dated as of July 1994, to Credit Agreement among the
         Registrant and The Chase Manhattan Bank, N.A. (incorporated by
         reference to Exhibit 6(a) to the Registrant's Quarterly Report on Form
         10-Q for the quarter ended June 30, 1994)).

10.5     Amendment Five, dated as of March 21, 1995, to Credit Agreement among
         the Registrant and The Chase Manhattan Bank, N.A. (incorporated by
         reference to Exhibit 10.7 to the Registrant's Current Report on Form
         8-K dated March 21, 1995 (the "March 8-K")).

10.5(1)  Form of Warrants issued to The Bank of New York, The Chase Manhattan
         Bank, N.A. and the Israel Discount Bank (incorporated by reference to
         Exhibit 10.5(i) to the Registrant's Annual Report on Form 10-K for the
         year ended December 31, 1995 (the "1995 Form 10-K")).

10.5(2)  Letter Agreement, dated July 10, 1995, among Halsey Drug Co.,Inc., The
         Chase Manhattan Bank, N.A., The Bank of New York and Israel Discount
         Bank of New York (incorporated by reference to Exhibit 6(a) to the
         Registrant's Quarterly Report on Form 10-Q for the quarter ended June
         30, 1995 (the "June 10-Q")).

10.5(3)  Letter Agreement, dated November 16, 1995, among Halsey Drug Co.,Inc.,
         The Chase Manhattan Bank, N.A., The Bank of New York and Israel
         Discount Bank of New York (incorporated by reference to Exhibit
         10.25(iv) to the 1995 10-K).

                                       37

<PAGE>   79
Exhibit
Number   Document
- ------   --------

10.5(4)  Amendment 6, dated as of August 6, 1996, to Credit Agreement among
         Halsey Drug Co.,Inc., The Chase Manhattan Bank, N.A., The Bank of New
         York and Israel Discount Bank of New York (incorporated by reference to
         Exhibit 10.1 to Amendment No. 1 to the Registrant's Quarterly Report on
         Form 10-Q for the quarter ended June 30, 1996 (the "June 1996 10-Q)).

10.5(5)  Letter Agreement, dated March 25, 1997 among Halsey Drug Co., Inc., The
         Chase Manhattan Bank, as successor in interest to The Chase Manhattan
         Bank (National Association), The Bank of New York and Israel Discount
         Bank.

10.6     Agreement Regarding Release of Security Interests dated as of March 21,
         1995 by and among the Company, Mallinckrodt Chemical Acquisition, Inc.
         and The Chase Manhattan Bank, N.A.(incorporated by reference to Exhibit
         10.9 of the March 8-K).

10.7     Consulting Agreement dated as of September, 1993 between the Registrant
         and Joseph F. Limongelli (incorporated by reference to Exhibit 10.6 to
         the 1993 Form 10-K).

10.8     Employment Agreement, dated as of January 1, 1993, between the
         Registrant and Rosendo Ferran (incorporated by reference to Exhibit
         10.2 to the 1992 Form 10-K).

10.10(1) Halsey Drug Co., Inc. 1984 Stock Option Plan, as amended (incorporated
         by reference to Exhibit 10.3 to the 1992 Form 10-K).

10.10(2) Halsey Drug Co., Inc. 1995 Stock Option and Restricted Stock Purchase
         Plan (incorporated by reference to Exhibit 4.1 to the Registrant's
         Registration Statement on Form S-8, File No. 33-98396).

10.10(3) Halsey Drug Co., Inc. Non-Employee Director Stock Option Plan.

10.11    Leases, effective February 13, 1989 and January 1, 1990, respectively,
         among the Registrant and Milton J. Ackerman, Sue Ackerman, Lee
         Hinderstein, Thelma Hinderstein and Marilyn Weiss (incorporated by
         reference to Exhibits 10.6 and 10.7, respectively, to the Registrant's
         Annual Report on Form 10-K for the year ended December 31, 1989).

10.12    Lease, effective as of April 15, 1988, among the Registrant and Milton
         J. Ackerman, Sue Ackerman, Lee Hinderstein, Thelma Hinderstein and
         Marilyn Weiss, and Rider thereto (incorporated by reference to Exhibit
         10.12 to the Registrant's Annual Report on Form 10-K for the year ended
         December 31, 1987).

10.12(l) Lease, as of October 31, 1994, among Registrant and Milton J. Ackerman,
         Sue Ackerman, Lee Hinderstein, Thelma Hinderstein and Marilyn Weiss,
         together with Modification, Consolidation and Extension Agreement
         (incorporated by reference to Exhibit 10. 12(i) to the Registrant's
         Annual Report on Form 10-K for the year ended December 31, 1995).

10.13    Asset Purchase Agreement dated as of March 21, 1995 among Mallinckrodt
         Chemical Acquisition, Inc. ("Acquisition"), Mallinckrodt Chemical,
         Inc., as guarantor and the Registrant (incorporated by reference to
         Exhibit 10.1 to the March 8-K).

                                       38

<PAGE>   80
Exhibit
Number   Document
- ------   --------

10.14    Toll Manufacturing Agreement for APAP/Oxycodone Tablets dated as of
         March 21, 1995 between Acquisition and the Registrant (incorporated by
         reference to Exhibit 10.2 to the March 8-K).

10.15    Capsule ANDA Option Agreement dated as of March 21, 1995 between
         Acquisition and the Registrant (incorporated by reference to Exhibit
         10.3 to the March 8-K).

10.16    Tablet ANDA Noncompetition Agreement dated as of March 21, 1995 between
         the Registrant and Acquisition (incorporated by reference to Exhibit
         10.4 to the March 8-K).

10.17    Subordinated Non-Negotiable Promissory Term Note in the amount of
         $1,200,00 dated March 21, 1995 issued by the Registrant to Acquisition
         (incorporated by reference to Exhibit 10.5 to the March 8-K).

10.18    Term Note Security Agreement dated as of March 21, 1995 among the
         Company, Houba, Inc. and Acquisition (incorporated by reference to
         Exhibit 10.6 to the March 8-K).

10.19    Amendment dated March 21, 1995 to Subordination Agreement dated as of
         July 21, 1994 between Mallinckrodt Chemical, Inc., Mallinckrodt
         Chemical Acquisition, Inc., the Registrant, The Chase Manhattan Bank
         (National Association), Israel Discount Bank of New York, The Bank of
         New York, and The Chase Manhattan Bank (National Association)
         (incorporated by reference to Exhibit 10.8 to the March 8-K).

10.20    Agreement dated as of March 30, 1995 between the Registrant and
         Zatpack, Inc. (incorporated by reference to Exhibit 10.10 to the March
         8-K).

10.21    Waiver and Termination Agreement dated as of March 30, 1995 between
         Zuellig Group, W.A., Inc. and Indiana Fine Chemicals Corporation
         (incorporated by reference to Exhibit 10.11 to the March 8-K).

10.22    Convertible Subordinated Note of the Registrant dated December 1, 1994
         issued to Zatpack, Inc. (incorporated by reference to Exhibit 10.12 to
         the March 8-K).

10.23    Agreement dated as of March 30, 1995 among the Registrant, Indiana Fine
         Chemicals Corporation, Zuellig Group, N.A., Inc., Houba Inc.,
         ZetaPharm, Inc. and Zuellig Botanicals, Inc. (incorporated by reference
         to Exhibit 10.13 to the March 8-K).

10.24    Supply Agreement dated as of March 30, 1995 between Houba, Inc. and
         ZetaPharm, Inc. (incorporated by reference to Exhibit 10.14 to the
         March 8-K).

10.25    Form of 10% Convertible Subordinated Debenture (incorporated by
         reference to Exhibit 6(a) to the June 10-Q).

10.26    Form of Redeemable Common Stock Purchase Warrant (incorporated by
         reference to Exhibit 6(a) to the June 10-Q).

10.27    Form of 10% Convertible Subordinated Debenture (incorporated by
         reference to Exhibit 4.1 to the Registrant's Current Report on Form 8-K
         dated December 4, 1995 (the "December 8- K")).

                                       39

<PAGE>   81

Exhibit
Number   Document
- ------   --------

10.28    Form of Redeemable Common Stock Purchase Warrant (incorporated by
         reference to Exhibit 4.2 to the December 8-K).

10.29    Form of 10% Convertible Subordinated Debenture (incorporated by
         reference to Exhibit 99 to the June 1996 10-Q).

10.30    Form of Redeemable Common Stock Purchase Warrant (incorporated by
         reference to Exhibit 4.1 to Amendment No. 1 to the June 1996 10-Q).

10.31    Form of 5% Convertible Senior Secured Debenture (incorporated by
         reference to Exhibit 4.1 to the Registrant's Current Report on Form 8-K
         dated March 24, 1998 (the "March 1998 8- K")).

10.32    Form of Common Stock Purchase Warrant (incorporated by reference to
         Exhibit 4.2 to the March 1998 8-K).

10.33    Debenture and Warrant Purchase Agreement dated March 10, 1998, by and
         among the Registrant, Galen Partners III, L.P. and the other Purchasers
         listed on the Signature Page thereto (incorporated by reference to
         Exhibit 10.1 to the March 1998 8-K).

10.34    Form of General Security Agreement of Halsey Drug Co., Inc. dated March
         10, 1998 (incorporated by reference to Exhibit 10.2 to the March 1998
         8-K).

10.35    Form of Agreement of Guaranty of Subsidiaries of Halsey Drug Co., Inc.
         dated March 10, 1998 (incorporated by reference to Exhibit 10.3 to the
         March 1998 8-K).

10.36    Form of Guarantor General Security Agreement dated March 10, 1998
         (incorporated by reference to Exhibit 10.4 to the March 1998 8-K).

10.37    Stock Pledge Agreement dated March 10, 1998 by and between the
         Registrant and Galen Partners III, L.P., as agent (incorporated by
         reference to Exhibit 10.5 to the March 1998 8-K).

10.38    Form of Irrevocable Proxy Agreement (incorporated by reference to
         Exhibit 10.6 to the March 1998 8-K).

10.39    Agency Letter Agreement dated March 10, 1998 by and among the
         Purchasers a party to the Debenture and Warrant Purchase Agreement,
         dated March 10, 1998 (incorporated by reference to Exhibit 10.7 to the
         March 1998 8-K).

10.40    Press Release of Registrant dated March 13, 1998 (incorporated by
         reference to Exhibit 99.1 to the March 1998 8-K).

10.41    Current Report on Form 8-K as filed by the Registrant with the
         Securities and Exchange Commission on March 24, 1998.

*10.42   Letter Agreement between the Registrant and the U. S. Department of
         Justice dated March 27, 1998 relating to the restructuring of the fine
         assessed by the Department of Justice under the Plea Agreement dated
         June 21, 1993.

                                       40

<PAGE>   82
Exhibit
Number   Document
- ------   --------
*10.43   Employment Agreement dated as of March 10, 1998 between the Registrant
         and Michael K. Reicher

*10.44   Employment Agreement dated as of March 10, 1998 between the Registrant
         and Peter Clemens 

21       Subsidiaries of the Registrant (incorporated by reference to Exhibit 22
         to the 1993 Form 10-K).

*23.1    Consent of Grant Thornton LLP, independent certified public
         accountants.

*27      Financial Data Schedule, which is submitted electronically to the
         Securities and Exchange Commission for informational purposes only and
         not filed.

- -----------------
*  Filed herewith.

                                                                                

                                       41





<PAGE>   1
                                                                   Exhibit 10.42

                                 March 27, 1998



VIA FAX (202) 234-1560

John R. Fleder
Olsson, Frank and Weeda, P.C.
Suite 400
1400 Sixteenth Street, N.W.
Washington, D.C. 20036

                  Re:      Halsey Drug Company

Dear Mr. Fleder:

         As you know, Halsey Drug Company (Halsey) has not made any payment in
the settlement of the criminal fine that was imposed on it by the United States
District Court for the District of Maryland since May 1996. Payment of the fine
has thus been long delinquent and the United State could, at this time, declare
the fine to be in default and initiate a collection action for the full amount
of the fine that remains unpaid, $2.15 million, and additional monetary
penalties pursuant to 18 U.S.C. Section 3612.

         Rather than initiate such action at this time, I propose the following
alternatives. The first alternative is that Halsey pay the full amount now due,
$2.15 million, by May 1, 1998, in full satisfaction of the fine. If Halsey is
not able to make such payment by that date, I suggest that, pursuant to 18
U.S.C. Section 3614, we jointly move the Court to modify the original sentence
that was imposed on July 23, 1993.

         The sentence imposed by the Court included a fine of $2,500,000, but
provided that it be payable pursuant to the following schedule: $125,000 was to
be
 paid within 60 days of sentencing and an additional $125,000 was to be paid
every 90 days thereafter until the fine was paid in full.
The interest requirement was waived.

         In light of its current financial circumstances I propose that both
Halsey and the United States ask the Court to modify the sentence to allow for
the following payment schedule and to provide the additional conditions set
forth below.




<PAGE>   2



         1. Interest shall accrue on all outstanding balances at the rate
calculated pursuant to 28 U.S.C. Section 1961, from the date on which the Court
modifies the fine payment schedule until the fine and all accrued interest and
penalty is paid in full.

         2. Halsey shall, beginning on May 1, 1998, cause a check drawn in the
amount of twenty-five thousand dollars ($25,000), plus all accrued interest, to
be made payable to the Clerk of the United States District Court every month.
These monthly payments, via certified check, shall continue thereafter and be
sent by Halsey so as to be received by the Clerk of the U.S. District Court for
the District of Maryland in Baltimore, by the 7th day of each month. These
monthly payments shall continue until Halsey has paid off all of its financial
obligations to the United States which have arisen from this case. (When the 7th
of any month falls on Saturday, Sunday or a Holiday, the payments shall be sent
so that they are received by the Clerk of Court in Baltimore no later than the
first business day after the 7th of the month).

         3. Until such time as this fine, including all applicable interest and
penalties (the debt) is paid in full the United States shall have full access to
all financial records of Halsey. All financial information requested by the
Court or the United States shall be provided promptly.

         4. Until such time as this debt is paid in full Halsey shall not in any
calendar year pay (or obligate itself to pay) to any individual (or on behalf of
any individual) more than $150,000 without the prior written consent of the
United States or an order of the U.S. District Court for the District of
Maryland. The United States may withhold this consent only if it concludes that
these payments are inconsistent with salaries generally paid for similar
positions in the pharmaceutical industry in the New York City area and such
payments would inhibit Halsey's ability to pay its debt to the United States as
outlined in this agreement. Halsey shall provide all information that the United
States requests in order for it to make these determinations. Halsey, however,
considers the information which it provides about the compensation paid its
employee to be exempt from disclosure under the Freedom of Information Act. If
the United States has not responded to Halsey's request within 30 days, or if
Halsey believes that the United States has inappropriately withheld its consent,
Halsey may petition the District Court for authorization to pay the salary and
or any other compensation which its management considers appropriate. In any
petition to the District Court, Halsey will bear the burden of proof that its
proposed compensation is reasonable and appropriate.

         5. Until such time as this debt is paid in full, if Halsey earns an
after tax profit in any calendar year, as determined by generally accepted
accounting principles, a sum equal to the lesser of the remaining debt or 25% of
that profit shall, within 90 days of the close of the fiscal year, be paid to
the United States in further payment of the principal on this fine.

         6. Until such time as this debt is paid in full, if Halsey sells any
capital asset (or group of assets) for a sum in excess of $10,000 it shall
either invest the entire sum in another capital asset, or within 90 days pay a
sum equal to the lesser of the remaining debt or 25% of the proceeds of that
sale to the United States in further payment of the principal on this fine.





<PAGE>   3


         7. If this proposal is accepted by the Court and Halsey makes all
payments as specified in this proposal, and pays on time and in full the fine
and all interest that may have accrued thereon, at that time, the Government
will waive any penalty that could be assessed pursuant to 18 U.S.C. Section
3612(g). If at any time after a modified sentencing order is entered, Halsey
does not make the required payments in a timely fashion, the United States will
be free to declare that the fine is delinquent and/or in default, and exercise
all legal process to immediately collect the full amount of the fine, interest
and applicable penalties.

         This proposal is made subject to the approval of the U.S. Attorney for
the District of Maryland and the U.S. District Court. If for any reason such
approval is not forthcoming, both the United States and Halsey retain all rights
and obligations that now exist.

         I have submitted this proposal to the U.S. Attorney for approval, and I
ask that you promptly submit this proposal to your client for its approval.

                                                  Sincerely,



                                                  /s/ Lawrence G. McDade
                                                  ---------------------------
                                                  Lawrence G. McDade
                                                  Deputy Director
                                                  Office of Consumer Litigation
                                                  U.S. Department of Justice
                                                  1331 Pennsylvania Avenue, N.W.
                                                  Suite 950 North
                                                  Washington, D.C. 20004
                                                  (202) 307-0138

cc:      AUSA Barbara S. Sale



<PAGE>   1
                                                                   EXHIBIT 10.43



                              EMPLOYMENT AGREEMENT

                  EMPLOYMENT AGREEMENT made as of the 10th day of March, 1998
between and among HALSEY DRUG CO., INC., a New York corporation (the
"Corporation"), with principal executive offices at 1827 Pacific Street,
Brooklyn, New York 11233 and MICHAEL K. REICHER residing at 2264 Churchview
Drive, Apt. 10, Rockford, Illinois 61107 (the "Employee").

                               W I T N E S S E T H

                  WHEREAS, the Corporation desires to employ the Employee to
engage in such activities and to render such services as are required under the
terms and conditions hereof and the Board of Directors has authorized and
approved the execution of this Agreement; and

                  WHEREAS, the Employee desires to be employed by the
Corporation under the terms and conditions hereinafter provided,

                  WHEREAS, the Corporation is engaged in the generic drug
business as a manufacturer, packager, distributor, and wholesaler thereof and in
the development of new generic drugs.

                  NOW, THEREFORE, in consideration of the mutual covenants and
undertakings herein contained, the parties agree as follows:

         1.       Employment, Duties and Acceptance.

                  1.1 Services. The Corporation hereby employs Employee, for the
Term (as hereinafter defined in Section 2 hereof), to render exclusive
 and
full-time services to the business and affairs of the Corporation as the Chief
Executive Officer and President of the Corporation, subject to the direction and
control of the Board of Directors of the Corporation, and, in connection

<PAGE>   2
therewith, the Employee shall be responsible for the day-to-day operations of
the Corporation, for development and implementation of annual operating plans,
annual capital plans and strategic plans, and to perform such other duties
consistent with the office of the Chief Executive Officer and President as he
shall reasonably be directed or requested to perform by the Board of Directors,
to whom he shall report, and to use his best efforts, skill and abilities to
promote the interests of the Corporation and its subsidiaries. Employee shall
not be required to relocate his residence to the New York/New Jersey
metropolitan area as a condition of his employment. Employee shall, however,
spend as much time in the NY/NJ area as may be required in the exercise of his
best judgment for the successful operation of the Corporation.

                  1.2 Acceptance. Employee hereby accepts such employment and
agrees to render the services described in Section 1.1 hereof.

         2.       Term of Employment.

                  The term of Employee's employment under this Agreement shall
commence on the date of this Agreement and shall terminate on February 28, 2003
(the "Initial Term"), unless sooner terminated pursuant to Section 8 of this
Agreement; provided, however, that if the Corporation shall fail to give
Employee written notice of non-renewal of Employee's employment with the
Corporation not less than 180 days prior to the Initial Term or any Renewal
Period (as defined), Employee's term hereunder shall automatically be extended
for successive one (1) year periods (each a "Renewal Period" and together with
the Initial Term, the "Term").

         3. Compensation. In consideration of the services to be rendered by the
Employee pursuant to this Agreement, the Employee shall receive from the
Corporation the following compensation:


                                        2

<PAGE>   3
                  (a) Base Salary. The Corporation shall pay the Employee an
aggregate base salary at the annual rate of $175,000, payable in equal bi-weekly
installments, less such deductions or amounts to be withheld as shall be
required by applicable laws and regulations.

         The Employee's Base Salary shall be subject to increase at the
discretion of the Board of Directors of the Corporation, in its sole discretion.

                  (b) Annual Bonus. During the Term, Employee shall be entitled
to receive from the Corporation an annual bonus in respect of each fiscal year,
or portion thereof, of the Corporation as follows:

                           (1) commencing with the Corporation's 1998 fiscal
year (ending December 31, 1998), in an amount of $93,750, provided that net
sales of the Corporation for the year ending December 31, 1998 are not less than
$28,000,000; and

                           (2) thereafter in accordance with such targets,
conditions or parameters as may be determined from time to time hereafter by the
Compensation Committee of the Board of Directors of the Corporation in its sole
and absolute discretion.

         4.       Expenses.

                  The Corporation shall pay or reimburse Employee for all
reasonable expenses which are in accordance with the Corporation's expense
policy in force from time to time and which are actually incurred or paid by him
during the Term in the performance of his services under this Agreement, upon
presentation of expense statements or vouchers or such other supporting
information as the Corporation may require.

         5.       Additional Benefits.

                           (a) In General. In addition to the compensation and
expenses to be paid under


                                        3

<PAGE>   4
Sections 3 and 4 hereof, Employee will be entitled to all rights and benefits
for which he shall be eligible under any insurance, profit-making, incentive,
bonus, stock option, pension or other extra compensation or "fringe" benefit
plan of the Corporation or any of its subsidiaries now existing or hereafter
adopted for the benefit of the executives or employees generally of the
Corporation.

                  (b) Stock Options. Employee is hereby granted stock options to
purchase 1,000,000 shares of the Corporation's common stock, $.01 par value per
share (the "Option") at an exercise price of $2.375 per share (representing the
closing price for the Company's common stock as reported by the American Stock
Exchange on Wednesday, February 18, 1998) (the "Option Shares"). The Option
shall vest and be exercisable in an amount equal to 62,500 Option Shares at the
end of each quarterly period during the Term (the first quarterly vesting period
to be satisfied on May 1, 1998 and on each August 1, November 1, and February 1,
thereafter until fully vested). The Option shall have a ten year term, subject
to earlier termination as set forth in paragraph 5(c) upon the termination of
Employee's employment with the Corporation and shall be evidenced by the
Corporation's standard form stock option agreement. The Employee and the
Corporation agree that the Option shall be deemed to have been issued pursuant
to one or more plans for the grant of incentive stock options, to the maximum
extent permitted by law, and non-qualified stock options. The exercise price and
terms of any non-qualified options shall be subject to such revisions as the
Employee and the Corporation may agree.

                  (c) Purchase of Options. In the event that Employee is
terminated for cause (as defined in paragraph 8.3) or resigns, the Corporation
shall have the right, but not the obligation, to purchase Employee's vested
Option at the Fair Market Value thereof. In the event that the Corporation does
not elect to purchase Employee's vested Option within seven days of the date of


                                        4

<PAGE>   5
Employee's termination for cause or resignation, Employee shall be obligated to
exercise his Options in writing within 37 days of such termination or
resignation, failing which he shall be deemed to have forfeited his Option to
the Corporation. For purposes of this paragraph 5(c), "Fair Market Value" shall
mean the product of (i) the positive difference, if any, between the average of
the closing price of the Company's Common Stock as reported by the American
Stock Exchange, or such other exchange or over-the-counter market on which the
Company's Common Stock may then be listed or admitted for trading, for the five
(5) trading days prior to the date of termination, multiplied by (ii) the number
of Option Shares which, as of the date of termination, are vested under the
Option.

                  (d) Automobile. The Corporation shall provide the Employee
with a company car and shall reimburse the Employee for all gasoline, insurance
and maintenance expense associated with the Employee's automobile, to the extent
deductible by the Corporation under applicable federal laws and regulations.

         6. Vacation.

                  Employee shall be entitled to a vacation period of not less
than four weeks during each year of the Term, to be taken at a time or times
acceptable to the Corporation.

         7. Insurability; Right to Insure. Employee represents and warrants to
the Corporation that, to the best of his knowledge, on the date hereof he is,
and upon the commencement of the Term he will be, insurable at standard premium
rates. Employee agrees that the Corporation shall have the right during the Term
to insure the life of Employee by a policy or policies of insurance in such
amount or amounts as it may deem necessary or desirable, and the Corporation
shall be the beneficiary of any such policy or policies and shall pay the
premiums or other costs thereof. The


                                        5

<PAGE>   6
Corporation shall have the right, from time to time, to modify any such policy
or policies of insurance or to take out new insurance on the life of Employee.
Employee agrees, upon request, at any time or times prior to the commencement of
or during the Term to sign and deliver any and all documents and to submit to
any physical or other reasonable examinations which may be required in
connection with any such policy or policies of insurance or modifications
thereof.

         8.       Termination.

                  8.1 Death. If during the Term Employee shall die, Employee's
employment under this Agreement shall terminate as of the date of Employee's
death. The base salary payable hereunder to or for the benefit of Employee
through the date of death shall be paid to such person or persons ("Employee's
Designees") as Employee may designate by notice to the Corporation from time to
time or, in the absence of such designation, to his spouse. In addition, the
Corporation shall pay the Employee's Designees an amount equal to six months'
base salary plus 1/12th of the bonus the Employee would have received had he
been alive at the end of the year in which he died, for each complete calendar
month from January 1 of the year in which the Employee died, to his date of
death.

                  8.2 Disability. In the event of the Employee's "mental or
physical disability" (as defined herein) which continues for (i) a period of
longer than 90 consecutive days, or (ii) such periods aggregating 120 days
during any 365 consecutive days, such that the Employee is, despite reasonable
accommodation, unable to substantively perform the essential functions of his
position for said period, the determination of which shall be confirmed by the
Board of Directors in the manner hereinafter provided, this Agreement shall
terminate upon thirty (30) days' prior written notice to the Employee from the
Corporation (the "Disability Termination Date"). The Corporation


                                        6

<PAGE>   7
shall continue to pay to the Employee during the period of his mental or
physical disability the base salary and annual bonus provided in Section 3 of
this Agreement as well as provide the benefits described herein; provided,
however, that the base salary shall be reduced by any disability insurance
payments paid to the Employee. On the Disability Termination Date, Employee's
base salary shall cease but the Employee shall be entitled to the annual bonus
computed in accordance with Section 3(b) hereof for the period ending on the
Disability Termination Date. Except for the bonus payment required in the
preceding sentence, no annual bonus will accrue or be payable by the Corporation
following the Disability Termination Date.

                  As used herein, the term "mentally or physically disabled"
shall have the meaning ascribed thereto in the disability insurance policy then
in force and effect with respect to the Employee or, if no such disability
policy then exists, it shall mean the inability of the Employee, by reason of
injury, illness or other similar cause to perform a material part of his duties
and responsibilities in connection with the conduct of the business and affairs
of the Corporation as determined by a reputable physician of the Corporation's
selection, who has examined the Employee with his consent.

                  8.3 Termination For Cause. The Corporation may at any time
during the Term, by written notice, and after affording the Employee the
opportunity to be heard in person by the Board of Directors, terminate this
Agreement and discharge Employee for "cause", whereupon the Corporation's
obligation to pay compensation or any other amounts payable hereunder to or for
the benefit of Employee shall terminate on the date of such discharge except for
accrued and unpaid salary and expenses to the date of discharge. For purposes of
this Agreement, the term "cause" shall mean (i) excessive absenteeism,
alcoholism or drug abuse, (ii) fraud, misappropriation or intentional


                                        7

<PAGE>   8
material damage to the property or business of the Corporation; (iii) conviction
of a felony; (iv) failure of the Employee to perform his duties in accordance
with this Agreement after written notice to the Employee by the Board of
Directors specifying such failure and giving the Employee eight (8) days to
correct the defects in performance; or (v) breach by the Employee of any
material provision hereof which, if capable of remedy, remains unremedied for
more than 10 days after written notice.

                  8.4 Termination without Cause. The Corporation shall have the
option to terminate this Agreement without cause upon thirty (30) days' written
notice to the Employee. In the event the Corporation terminates this Agreement
pursuant to this Section 8.4, the Corporation shall pay the Employee an amount
equal to (a) his then accrued and unpaid base salary and bonuses through and
including the date of termination, and (b) $350,000 or twice his then Base
Salary, whichever is greater payable in 24 equal monthly installments. Upon
termination of Employee's employment with the Corporation pursuant to this
Section 8.4, (i) Employee's outstanding Options shall vest in full,
notwithstanding any contrary vesting schedule contained herein or in any option
agreement between the Corporation and the Employee and shall be exercised within
90 days of the date of vesting, and (ii) the provisions of paragraph 9.3 shall
be deemed of no force or effect.

                  Subject to paragraph 8.4(ii), the obligations of the Employee
under Section 9 shall continue notwithstanding the termination of Employee's
employment pursuant to this Section 8.4 provided the Corporation complies with
its obligations specified in this paragraph.

                  8.5 Change of Control. Upon the sale or transfer of more than
50% of the outstanding shares of the Corporation (other than to Galen Associates
or any of its affiliates) or upon the sale of the whole or a major part of the
business of the Corporation, Employee shall be entitled


                                        8

<PAGE>   9
to terminate this Agreement on the same terms and conditions as set forth in
Section 8.4.

         9. Protection of Confidential Information. In view of the fact that
Employee's work for the Corporation will bring him into close contact with all
the confidential affairs thereof, and plans for future developments, Employee
agrees to the following:

                  9.1 Secrecy. During the term of Employment and for two (2)
years thereafter, to preserve the confidential nature of, and not disclose,
reveal, or make accessible to anyone other than the Corporation's officers,
directors, employees, consultants or agents, otherwise than within the scope of
his employment duties and responsibilities hereunder, any and all documents,
information, knowledge or data of or pertaining to the Corporation, its
subsidiaries or affiliates or pertaining to any other individual, firm,
corporation, partnership, joint venture, business, organization, entity or other
person with which the Corporation or any of its subsidiaries or affiliates may
do business during the Term of Employment (including licensees, licensors,
manufacturers, suppliers and customers of the Corporation or any of its
subsidiaries or affiliates) and which is not in the public domain, including
trade secrets, "know how", names and lists of licensees, licensors,
manufacturers, suppliers and customers, programs, statistics, manufacturing and
production methods, processes, techniques, pricing, marketing methods and plans,
specifications, advertising plans and campaigns or any other matters, and all
other confidential information of the Corporation, its subsidiaries and
affiliates acquired in connection with Employee's employment (hereinafter
referred to as "Confidential Information"). The restrictions on the disclosure
of Confidential Information imposed by this Subparagraph 9.1 shall not apply to
any Confidential Information that was part of the public domain at the time of
its receipt by the Employee or becomes part of the public domain in any manner
and for any reason other than an act by the Employee, unless the Employee is
legally


                                        9

<PAGE>   10
compelled (by deposition, interrogatory, request for documents, subpoena, civil
investigative demand or similar process) to disclose such Confidential
Information, in which event Employee shall provide the Corporation with prompt
notice of such requirement so that the Corporation may seek a protective order
or other appropriate remedy, and if such protective order or other remedy is not
obtained, Employee shall exercise reasonable efforts in good faith to obtain
assurance that confidential treatment will be accorded such Confidential
Information.

                  9.2 Return Memoranda, etc. To deliver promptly to the
Corporation on termination of his employment, or at any other time the
Corporation may so request, all memoranda, notes, records, reports, manuals,
drawings, blueprints and other documents (and all copies thereof) relating to
the Corporation's business and all property associated therewith, which he may
then possess or have under his control.

                  9.3 Non-competition. Provided that this Agreement has not been
breached by the Corporation, the Employee agrees that he shall not at any time
prior to two years after the earlier to occur of (i) the expiration of the Term
hereunder and (ii) the termination of his employment with the Corporation, own,
manage, operate, be a director or an employee of, or a consultant to any
business or corporation which is conducting any business within the generic drug
industry or which competes with or conducts the same business as or similar to
that conducted by the Corporation in the United States. The Employee further
agrees that, provided this Agreement has not been breached by the Corporation,
he shall not, at any time prior to two years after the earlier to occur of (i)
the expiration of the Term hereunder and (ii) the termination of his employment
with the Corporation, assist or allow any such business or corporation to hire
anyone who was employed by the Corporation at such time or at any time during
the preceding twelve months. If any of the provisions of this section, or


                                       10

<PAGE>   11
any part thereof, is hereinafter construed to be invalid or unenforceable, the
same shall not affect the remainder of such provision or provisions, which shall
be given full effect, without regard to the invalid portions. If any of the
provisions of this section, or any part thereof, is held to be unenforceable
because of the duration of such provision, the area covered thereby or the type
of conduct restricted therein, the parties agree that the court making such
determination shall have the power to modify the duration, geographic area
and/or other terms of such provision and, as so modified, said provision shall
then be enforceable. In the event that the courts of any one or more
jurisdictions shall hold such provisions wholly or partially unenforceable by
reason of the scope thereof or otherwise, it is the intention of the parties
hereto that such determination not bar or in any way affect the Corporation's
right to the relief provided for herein in the courts of any other jurisdictions
as to breaches or threatened breaches of such provisions in such other
jurisdictions, the above provisions as they relate to each jurisdiction being,
for this purpose, severable into diverse and independent covenants.

                  9.4 Injunctive Relief. The Employee acknowledges and agrees
that, because of the unique and extraordinary nature of his services, any breach
or threatened breach of the provisions of Sections 9.1, 9.2, or 9.3 hereof will
cause irreparable injury and incalculable harm to the Corporation, and the
Corporation shall, accordingly, be entitled to injunctive and other equitable
relief for such breach or threatened breach and that resort by the Corporation
to such injunctive or other equitable relief shall not be deemed to waive or to
limit in any respect any right or remedy which the Corporation may have with
respect to such breach or threatened breach.

                  9.5 Expenses of Enforcement of Covenants. In the event that
any action, suit or proceeding at law or in equity is brought to enforce the
covenants contained in Section 9.1, 9.2, or


                                       11

<PAGE>   12
9.3 hereof or to obtain money damages for the breach thereof, the party
prevailing in any such action, suit or other proceeding shall be entitled upon
demand to reimbursement from the other party for all expenses (including,
without limitation, reasonable attorneys' fees and disbursements) incurred in
connection therewith.

                  9.6 Non-Solicitation. Employee covenants and agrees not to,
directly or indirectly, during the Term of Employment and for a period of two
(2) years from and after the effective date of the termination of his employment
with the Corporation (for any reason whatsoever), (i) induce or attempt to
influence any employee of the Corporation or any of its subsidiaries or
affiliates to leave its employ, or (ii) aid any person, business, or firm,
including a supplier, a competitor, licensor or customer of or a manufacturer
for the Corporation, in any attempt to hire any person who shall have been
employed by the Corporation or any of its subsidiaries or affiliates within the
period of one (1) year of the date of any such requested aid.

         10.      Indemnification.

                  (a) The Corporation will defend and indemnify Employee, to the
maximum extent permitted by applicable law and the by-laws of the Corporation,
against all claims, costs, charges and expenses incurred or sustained by him in
connection with any action, suit or other proceeding to which he may be made a
party by reason of (i) his being an officer, director or employee of the
Corporation or of any subsidiary or affiliate thereof, or (ii) the Employee's
alleged employment of Employee by Ranbaxy Pharmaceuticals, Inc. or his alleged
termination thereafter.

                  (b) The Corporation will defend and indemnify Employee against
all costs, charges and expenses incurred or sustained by him in connection with
any action, suit or other proceeding to which he may be made a party by reason
of the Employee's prior employment by


                                       12

<PAGE>   13
Mylan Pharmaceuticals Inc. or any agreement executed in connection with such
employment; provided, however, that in no event shall such defense and indemnity
obligation exceed $25,000 in the aggregate.

         11.      Employee Warranties.

                  Employee hereby warrants that, except as may be alleged by
Ranbaxy Pharmaceuticals, Inc., as of the date hereof Employee is not employed
(other than by the Corporation) and is not a party to any other employment
contract, express or implied. Employee warrants that he has no other obligation,
contractual or otherwise, which would prevent him from accepting the
Corporation's offer of employment under the terms of this Agreement and from
complying with its provisions. Employee warrants that he will not utilize during
his employment hereunder any confidential information obtained through or in
connection with his prior employment. Employee warrants that he knows of no
reason why he would not be able to perform his obligations under this Agreement.

         12.      Notices.

                  All notices, requests, consents and other communications
required or permitted to be given hereunder, shall be in writing and shall be
deemed to have been duly given if delivered personally or sent by facsimile,
with confirmation of receipt, or mailed first-class, postage prepaid, by
registered or certified mail (notices sent by mail shall be deemed to have been
given on the date sent), to the parties at their respective addresses
hereinabove set forth or to such other address as either party shall designate
by notice in writing to the other in accordance herewith.

         13.      General.

                  13.1 Governing Law. This Agreement shall be governed by and
construed and


                                       13

<PAGE>   14
enforced in accordance with the local laws of the State of New York applicable
to agreements made and to be performed entirely in New York.

                  13.2 Captions. The section headings contained herein are for
reference purposes only and shall not in any way affect the meaning or
interpretation of this Agreement.

                  13.3 Entire Agreement. This Agreement sets forth the entire
agreement and understanding of the parties relating to the subject matter
hereof, and supersedes all prior agreements, arrangements and understandings,
written or oral, relating to the subject matter hereof. No representation,
promise or inducement has been made by either party that is not embodied in this
Agreement, and neither party shall be bound by or liable for any alleged
representation, promise or inducement not so set forth.

                  13.4 Assignability. This Agreement, and Employee's rights and
obligations hereunder, may not be assigned by Employee. The Corporation may
assign its rights, together with its obligations, hereunder in connection with
any sale, transfer or other disposition of all or substantially all of its
business or assets; in any event the rights and obligations of the Corporation
hereunder shall be binding on its successors or assigns, whether by merger,
consolidation or acquisition of all or substantially all of its business or
assets.

                  13.5 Amendment. This Agreement may be amended, modified,
superseded, canceled, renewed or extended and the terms or covenants hereof may
be waived, only by a written instrument executed by both of the parties hereto,
or in the case of a waiver, by the party waiving compliance. No superseding
instrument, amendment, modification, cancellation, renewal or extension hereof
shall require the consent or approval of any person other than the parties
hereto. The failure of either party at any time or times to require performance
of any provision hereof shall


                                       14

<PAGE>   15
in no matter affect the right at a later time to enforce the same. No waiver by
either party of the breach of any term or covenant contained in this Agreement,
whether by conduct or otherwise, in any one or more instances, shall be deemed
to be, or construed as, a further or continuing waiver of any such breach, or a
waiver of the breach of any other term or covenant contained in this Agreement.

                  13.6 Counterparts. This Agreement may be executed in one or
more counterparts, each of which shall be deemed an original, but all of which
taken together will constitute one and the same instrument.

                  13.7 Arbitration. Any dispute or controversy arising under or
in connection with this Agreement shall be settled exclusively by arbitration,
conducted before a panel of three arbitrators, in New York, New York, in
accordance with the commercial arbitration rules of the American Arbitration
Association then in effect. Judgment may be entered on the arbitrator's award in
any court having jurisdiction. The expense of such arbitration shall be borne as
directed by the arbitrator.

                  13.8 Severability. The provisions of this Agreement shall be
deemed severable, and if any part of any provision is held illegal, void or
invalid under applicable law, such provision may be changed to the extent
reasonably necessary to make the provision, as so changed, legal, valid and
binding. If any provision of this Agreement is held illegal, void or invalid in
its entirety, the remaining provisions of this Agreement shall not in any way be
affected or impaired but shall remain binding in accordance with their terms.

                  13.9 Fees and Costs. The Corporation will contribute not more
than $10,000 towards the fees and costs of Employee's counsel in connection with
the review of this Agreement and Peter Clemens' Agreement.


                                       15

<PAGE>   16
                  IN WITNESS WHEREOF, the parties have executed this Agreement
as of the date first above written.

ATTEST:                                             HALSEY DRUG CO., INC.

                                                    By: /s/ William Skelly
- -------------------                                     ------------------------
                                                        William Skelly, Chairman

WITNESS:                                            EMPLOYEE

                                                    By: /s/ Michael K. Reicher
- -------------------                                     ------------------------
                                                        Michael K. Reicher


                                       16



<PAGE>   1
                                                                   EXHIBIT 10.44



                              EMPLOYMENT AGREEMENT

                  EMPLOYMENT AGREEMENT made as of the 10th day of March, 1998
between and among HALSEY DRUG CO., INC., a New York corporation (the
"Corporation"), with principal executive offices at 1827 Pacific Street,
Brooklyn, New York 11233 and PETER CLEMENS residing at 20860 Valley Road,
Kideer, Illinois 60047 (the "Employee").

                               W I T N E S S E T H

                  WHEREAS, the Corporation desires to employ the Employee to
engage in such activities and to render such services as are required under the
terms and conditions hereof and the Board of Directors has authorized and
approved the execution of this Agreement; and

                  WHEREAS, the Employee desires to be employed by the
Corporation under the terms and conditions hereinafter provided,

                  WHEREAS, the Corporation is engaged in the generic drug
business as a manufacturer, packager, distributor, and wholesaler thereof and in
the development of new generic drugs.

                  NOW, THEREFORE, in consideration of the mutual covenants and
undertakings herein contained, the parties agree as follows:

         1.       Employment, Duties and Acceptance.

                  1.1 Services. The Corporation hereby employs Employee, for the
Term (as hereinafter defined in Section 2 hereof), to render exclusive and
full-time
 services to the business and affairs of the Corporation as the Chief
Financial Officer of the Corporation, subject to the direction and control of
the President and the Board of Directors of the Corporation, and, in

<PAGE>   2
connection therewith, the Employee shall be responsible for the duties normally
attendant with the position of Chief Financial Officer, and such other duties
consistent with the office of Chief Financial Officer as he shall reasonably be
directed or requested to perform by the President or the Board of Directors, to
whom he shall report, and to use his best efforts, skill and abilities to
promote the interests of the Corporation and its subsidiaries. Employee shall
not be required to relocate his residence to the New York/New Jersey
metropolitan area as a condition of his employment. Employee shall, however,
spend as much time in the NY/NJ area as may be required in the exercise of his
best judgment for the successful operation of the Corporation.

                  1.2 Acceptance. Employee hereby accepts such employment and
agrees to render the services described in Section 1.1 hereof.

         2.       Term of Employment.

                  The term of Employee's employment under this Agreement shall
commence on the date of this Agreement and shall terminate on February 28, 2001
302846-1(the "Initial Term"), unless sooner terminated pursuant to Section 8 of
this Agreement; provided, however, that if the Corporation shall fail to give
Employee written notice of non-renewal of Employee's employment with the
Corporation not less than 180 days prior to the Initial Term or any Renewal
Period (as defined), Employee's term hereunder shall automatically be extended
for successive one (1) year periods (each a "Renewal Period" and together with
the Initial Term, the "Term").

         3. Compensation. In consideration of the services to be rendered by the
Employee pursuant to this Agreement, the Employee shall receive from the
Corporation the following compensation:

                  (a) Base Salary. The Corporation shall pay the Employee an
aggregate base


                                        2

<PAGE>   3
salary at the annual rate of $140,000, payable in equal bi-weekly installments,
less such deductions or amounts to be withheld as shall be required by
applicable laws and regulations.

         The Employee's Base Salary shall be subject to increase at the
discretion of the Board of Directors of the Corporation, in its sole discretion.

                  (b) Annual Bonus. During the Term, Employee shall be entitled
to receive from the Corporation an annual bonus in respect of each fiscal year,
or portion thereof, of the Corporation as follows:

                           (1) commencing with the Corporation's 1998 fiscal
year (ending December 31, 1998), in an amount of $82,500, provided that net
sales of the Corporation for the year ending December 31, 1998 are not less than
$28,000,000; and

                           (2) thereafter in accordance with such targets,
conditions or parameters as may be determined from time to time hereafter by the
Compensation Committee of the Board of Directors of the Corporation in its sole
and absolute discretion.

         4.       Expenses.

                  The Corporation shall pay or reimburse Employee for all
reasonable expenses which are in accordance with the Corporation's expense
policy in force from time to time and which are actually incurred or paid by him
during the Term in the performance of his services under this Agreement, upon
presentation of expense statements or vouchers or such other supporting
information as the Corporation may require.

         5.       Additional Benefits.

                  (a) In General. In addition to the compensation and expenses
to be paid under Sections 3 and 4 hereof, Employee will be entitled to all
rights and benefits for which he shall be


                                        3

<PAGE>   4
eligible under any insurance, profit-making, incentive, bonus, stock option,
pension or other extra compensation or "fringe" benefit plan of the Corporation
or any of its subsidiaries now existing or hereafter adopted for the benefit of
the executives or employees generally of the Corporation.

                  (b) Stock Options. Employee is hereby granted stock options to
purchase 300,000 shares of the Corporation's common stock, $.01 par value per
share (the "Option") at an exercise price of $2.375 per share (representing the
closing price for the Company's common stock as reported by the American Stock
Exchange on Wednesday, February 18, 1998) (the "Option Shares"). The Option
shall vest and be exercisable in an amount equal to 25,000 Option Shares at the
end of each quarterly period during the Term (the first quarterly vesting period
to be satisfied on May 1, 1998 and on each August 1, November 1, and February 1,
thereafter until fully vested). The Option shall have a ten year term, subject
to earlier termination as set forth in paragraph 5(c) upon the termination of
Employee's employment with the Corporation and shall be evidenced by the
Corporation's standard form stock option agreement. The Employee and the
Corporation agree that the Option shall be deemed to have been issued pursuant
to one or more plans for the grant of incentive stock options, to the maximum
extent permitted by law, and non-qualified stock options. The exercise price and
terms of any non-qualified options shall be subject to such revisions as the
Employee and the Corporation may agree.

                  (c) Purchase of Options. In the event that Employee is
terminated for cause (as defined in paragraph 8.3) or resigns, the Corporation
shall have the right, but not the obligation, to purchase Employee's vested
Option at the Fair Market Value thereof. In the event that the Corporation does
not elect to purchase Employee's vested Option within seven days of the date of
Employee's termination for cause or resignation, Employee shall be obligated to
exercise his Options


                                        4

<PAGE>   5
in writing within 37 days of such termination or resignation, failing which he
shall be deemed to have forfeited his Option to the Corporation. For purposes of
this paragraph 5(c), "Fair Market Value" shall mean the product of (i) the
positive difference, if any, between the average of the closing price of the
Company's Common Stock as reported by the American Stock Exchange, or such other
exchange or over-the-counter market on which the Company's Common Stock may then
be listed or admitted for trading, for the five (5) trading days prior to the
date of termination, multiplied by (ii) the number of Option Shares which are
then vested under the Option.

                  (d) Automobile. The Corporation shall provide the Employee
with a company car and shall reimburse the Employee for all gasoline, insurance
and maintenance expense associated with the Employee's automobile, to the extent
deductible by the Corporation under applicable federal laws and regulations.

         6.       Vacation.

                  Employee shall be entitled to a vacation period of not less
than four weeks during each year of the Term, to be taken at a time or times
acceptable to the Corporation.

         7. Insurability; Right to Insure. Employee represents and warrants to
the Corporation that, to the best of his knowledge, on the date hereof he is,
and upon the commencement of the Term he will be, insurable at standard premium
rates. Employee agrees that the Corporation shall have the right during the Term
to insure the life of Employee by a policy or policies of insurance in such
amount or amounts as it may deem necessary or desirable, and the Corporation
shall be the beneficiary of any such policy or policies and shall pay the
premiums or other costs thereof. The Corporation shall have the right, from time
to time, to modify any such policy or policies of insurance or to take out new
insurance on the life of Employee. Employee agrees, upon request, at


                                        5

<PAGE>   6
any time or times prior to the commencement of or during the Term to sign and
deliver any and all documents and to submit to any physical or other reasonable
examinations which may be required in connection with any such policy or
policies of insurance or modifications thereof.

         8.       Termination.

                  8.1 Death. If during the Term Employee shall die, Employee's
employment under this Agreement shall terminate as of the date of Employee's
death. The base salary payable hereunder to or for the benefit of Employee
through the date of death shall be paid to such person or persons ("Employee's
Designees") as Employee may designate by notice to the Corporation from time to
time or, in the absence of such designation, to his spouse. In addition, the
Corporation shall pay the Employee's Designees an amount equal to six months'
base salary plus 1/12th of the bonus the Employee would have received had he
been alive at the end of the year in which he died, for each complete calendar
month from January 1 of the year in which the Employee died, to his date of
death.

                  8.2 Disability. In the event of the Employee's "mental or
physical disability" (as defined herein) which continues for (i) a period of
longer than 90 consecutive days, or (ii) such periods aggregating 120 days
during any 365 consecutive days, such that the Employee is, despite reasonable
accommodation, unable to substantively perform the essential functions of his
position for said period, the determination of which shall be confirmed by the
Board of Directors in the manner hereinafter provided, this Agreement shall
terminate upon thirty (30) days' prior written notice to the Employee from the
Corporation (the "Disability Termination Date"). The Corporation shall continue
to pay to the Employee during the period of his mental or physical disability
the base salary and annual bonus provided in Section 3 of this Agreement as well
as provide the benefits


                                        6

<PAGE>   7
described herein; provided, however, that the base salary shall be reduced by
any disability insurance payments paid to the Employee. On the Disability
Termination Date, Employee's base salary shall cease but the Employee shall be
entitled to the annual bonus computed in accordance with Section 3(b) hereof for
the period ending on the Disability Termination Date. Except for the bonus
payment required in the preceding sentence, no annual bonus will accrue or be
payable by the Corporation following the Disability Termination Date.

                  As used herein, the term "mentally or physically disabled"
shall have the meaning ascribed thereto in the disability insurance policy then
in force and effect with respect to the Employee or, if no such disability
policy then exists, it shall mean the inability of the Employee, by reason of
injury, illness or other similar cause to perform a material part of his duties
and responsibilities in connection with the conduct of the business and affairs
of the Corporation as determined by a reputable physician of the Corporation's
selection, who has examined the Employee with his consent.

                  8.3 Termination For Cause. The Corporation may at any time
during the Term, by written notice, and after affording the Employee the
opportunity to be heard in person by the Board of Directors, terminate this
Agreement and discharge Employee for "cause", whereupon the Corporation's
obligation to pay compensation or any other amounts payable hereunder to or for
the benefit of Employee shall terminate on the date of such discharge except for
accrued and unpaid salary and expenses to the date of discharge. For purposes of
this Agreement, the term "cause" shall mean (i) excessive absenteeism,
alcoholism or drug abuse, (ii) fraud, misappropriation or intentional material
damage to the property or business of the Corporation; (iii) conviction of a
felony; (iv) failure of the Employee to perform his duties in accordance with
this Agreement after written notice


                                        7

<PAGE>   8
to the Employee by the Board of Directors specifying such failure and giving the
Employee eight (8) days to correct the defects in performance; or (v) breach by
the Employee of any material provision hereof which, if capable of remedy,
remains unremedied for more than 10 days after written notice.

                  8.4 Termination without Cause. The Corporation shall have the
option to terminate this Agreement without cause upon thirty (30) days' written
notice to the Employee. In the event the Corporation terminates this Agreement
pursuant to this Section 8.4, the Corporation shall pay the Employee an amount
equal to (a) his then accrued and unpaid base salary and bonuses through and
including the date of termination, and (b) $280,000 or twice his then Base
Salary, whichever is greater payable in 24 equal monthly installments. Upon
termination of Employee's employment with the Corporation pursuant to this
Section 8.4, (i) Employee's outstanding Options shall vest in full,
notwithstanding any contrary vesting schedule contained herein or in any option
agreement between the Corporation and the Employee and shall be exercised within
90 days of the date of vesting, and (ii) the provisions of paragraph 9.3 shall
be deemed of no force or effect.

                  Subject to paragraph 8.4(ii), the obligations of the Employee
under Section 9 shall continue notwithstanding the termination of Employee's
employment pursuant to this Section 8.4 provided the Corporation complies with
its obligations specified in this paragraph.

                  8.5 Change of Control. Upon the sale or transfer of more than
50% of the outstanding shares of the Corporation (other than to Galen Associates
or any of its affiliates) or upon the sale of the whole or a major part of the
business of the Corporation, Employee shall be entitled to terminate this
Agreement on the same terms and conditions as set forth in Section 8.4.

         9. Protection of Confidential Information. In view of the fact that
Employee's work for


                                        8

<PAGE>   9
the Corporation will bring him into close contact with all the confidential
affairs thereof, and plans for future developments, Employee agrees to the
following:

                  9.1 Secrecy. During the term of Employment and for two (2)
years thereafter, to preserve the confidential nature of, and not disclose,
reveal, or make accessible to anyone other than the Corporation's officers,
directors, employees, consultants or agents, otherwise than within the scope of
his employment duties and responsibilities hereunder, any and all documents,
information, knowledge or data of or pertaining to the Corporation, its
subsidiaries or affiliates or pertaining to any other individual, firm,
corporation, partnership, joint venture, business, organization, entity or other
person with which the Corporation or any of its subsidiaries or affiliates may
do business during the Term of Employment (including licensees, licensors,
manufacturers, suppliers and customers of the Corporation or any of its
subsidiaries or affiliates) and which is not in the public domain, including
trade secrets, "know how", names and lists of licensees, licensors,
manufacturers, suppliers and customers, programs, statistics, manufacturing and
production methods, processes, techniques, pricing, marketing methods and plans,
specifications, advertising plans and campaigns or any other matters, and all
other confidential information of the Corporation, its subsidiaries and
affiliates acquired in connection with Employee's employment (hereinafter
referred to as "Confidential Information"). The restrictions on the disclosure
of Confidential Information imposed by this Subparagraph 9.1 shall not apply to
any Confidential Information that was part of the public domain at the time of
its receipt by the Employee or becomes part of the public domain in any manner
and for any reason other than an act by the Employee, unless the Employee is
legally compelled (by deposition, interrogatory, request for documents,
subpoena, civil investigative demand or similar process) to disclose such
Confidential Information, in which event Employee shall


                                        9

<PAGE>   10
provide the Corporation with prompt notice of such requirement so that the
Corporation may seek a protective order or other appropriate remedy, and if such
protective order or other remedy is not obtained, Employee shall exercise
reasonable efforts in good faith to obtain assurance that confidential treatment
will be accorded such Confidential Information.

                  9.2 Return Memoranda, etc. To deliver promptly to the
Corporation on termination of his employment, or at any other time the
Corporation may so request, all memoranda, notes, records, reports, manuals,
drawings, blueprints and other documents (and all copies thereof) relating to
the Corporation's business and all property associated therewith, which he may
then possess or have under his control.

                  9.3 Non-competition. Provided that this Agreement has not been
breached by the Corporation, the Employee agrees that he shall not at any time
prior to two years after the earlier to occur of (i) the expiration of the Term
hereunder and (ii) the termination of his employment with the Corporation, own,
manage, operate, be a director or an employee of, or a consultant to any
business or corporation which is conducting any business within the generic drug
industry or which competes with or conducts the same business as or similar to
that conducted by the Corporation in the United States. The Employee further
agrees that, provided this Agreement has not been breached by the Corporation,
he shall not, at any time prior to two years after the earlier to occur of (i)
the expiration of the Term hereunder and (ii) the termination of his employment
with the Corporation, assist or allow any such business or corporation to hire
anyone who was employed by the Corporation at such time or at any time during
the preceding twelve months. If any of the provisions of this section, or any
part thereof, is hereinafter construed to be invalid or unenforceable, the same
shall not affect the remainder of such provision or provisions, which shall be
given full effect, without regard to the


                                       10

<PAGE>   11
invalid portions. If any of the provisions of this section, or any part thereof,
is held to be unenforceable because of the duration of such provision, the area
covered thereby or the type of conduct restricted therein, the parties agree
that the court making such determination shall have the power to modify the
duration, geographic area and/or other terms of such provision and, as so
modified, said provision shall then be enforceable. In the event that the courts
of any one or more jurisdictions shall hold such provisions wholly or partially
unenforceable by reason of the scope thereof or otherwise, it is the intention
of the parties hereto that such determination not bar or in any way affect the
Corporation's right to the relief provided for herein in the courts of any other
jurisdictions as to breaches or threatened breaches of such provisions in such
other jurisdictions, the above provisions as they relate to each jurisdiction
being, for this purpose, severable into diverse and independent covenants.

                  9.4 Injunctive Relief. The Employee acknowledges and agrees
that, because of the unique and extraordinary nature of his services, any breach
or threatened breach of the provisions of Sections 9.1, 9.2, or 9.3 hereof will
cause irreparable injury and incalculable harm to the Corporation, and the
Corporation shall, accordingly, be entitled to injunctive and other equitable
relief for such breach or threatened breach and that resort by the Corporation
to such injunctive or other equitable relief shall not be deemed to waive or to
limit in any respect any right or remedy which the Corporation may have with
respect to such breach or threatened breach.

                  9.5 Expenses of Enforcement of Covenants. In the event that
any action, suit or proceeding at law or in equity is brought to enforce the
covenants contained in Section 9.1, 9.2, or 9.3 hereof or to obtain money
damages for the breach thereof, the party prevailing in any such action, suit or
other proceeding shall be entitled upon demand to reimbursement from the other
party for all


                                       11

<PAGE>   12
expenses (including, without limitation, reasonable attorneys' fees and
disbursements) incurred in connection therewith.

                  9.6 Non-Solicitation. Employee covenants and agrees not to,
directly or indirectly, during the Term of Employment and for a period of two
(2) years from and after the effective date of the termination of his employment
with the Corporation (for any reason whatsoever), (i) induce or attempt to
influence any employee of the Corporation or any of its subsidiaries or
affiliates to leave its employ, or (ii) aid any person, business, or firm,
including a supplier, a competitor, licensor or customer of or a manufacturer
for the Corporation, in any attempt to hire any person who shall have been
employed by the Corporation or any of its subsidiaries or affiliates within the
period of one (1) year of the date of any such requested aid.

         10.      Indemnification.

                  The Corporation will defend and indemnify Employee, to the
maximum extent permitted by applicable law and the by-laws of the Corporation,
against all claims, costs, charges and expenses incurred or sustained by him in
connection with any action, suit or other proceeding to which he may be made a
party by reason of his being an officer, director or employee of the Corporation
or of any subsidiary or affiliate thereof.

         11.      Employee Warranties.

                  Employee hereby warrants that as of the date hereof Employee
is not employed (other than by the Corporation) and is not a party to any other
employment contract, express or implied. Employee warrants that he has no other
obligation, contractual or otherwise, which would prevent him from accepting the
Corporation's offer of employment under the terms of this Agreement and from
complying with its provisions. Employee warrants that he will not utilize during
his


                                       12

<PAGE>   13
employment hereunder any confidential information obtained through or in
connection with his prior employment. Employee warrants that he knows of no
reason why he would not be able to perform his obligations under this Agreement.

         12.      Notices.

                  All notices, requests, consents and other communications
required or permitted to be given hereunder, shall be in writing and shall be
deemed to have been duly given if delivered personally or sent by facsimile,
with confirmation of receipt, or mailed first-class, postage prepaid, by
registered or certified mail (notices sent by mail shall be deemed to have been
given on the date sent), to the parties at their respective addresses
hereinabove set forth or to such other address as either party shall designate
by notice in writing to the other in accordance herewith.

         13.      General.

                  13.1 Governing Law. This Agreement shall be governed by and
construed and enforced in accordance with the local laws of the State of New
York applicable to agreements made and to be performed entirely in New York.

                  13.2 Captions. The section headings contained herein are for
reference purposes only and shall not in any way affect the meaning or
interpretation of this Agreement.

                  13.3 Entire Agreement. This Agreement sets forth the entire
agreement and understanding of the parties relating to the subject matter
hereof, and supersedes all prior agreements, arrangements and understandings,
written or oral, relating to the subject matter hereof. No representation,
promise or inducement has been made by either party that is not embodied in this
Agreement, and neither party shall be bound by or liable for any alleged
representation, promise or inducement not so set forth.


                                       13

<PAGE>   14
                  13.4 Assignability. This Agreement, and Employee's rights and
obligations hereunder, may not be assigned by Employee. The Corporation may
assign its rights, together with its obligations, hereunder in connection with
any sale, transfer or other disposition of all or substantially all of its
business or assets; in any event the rights and obligations of the Corporation
hereunder shall be binding on its successors or assigns, whether by merger,
consolidation or acquisition of all or substantially all of its business or
assets.

                  13.5 Amendment. This Agreement may be amended, modified,
superseded, canceled, renewed or extended and the terms or covenants hereof may
be waived, only by a written instrument executed by both of the parties hereto,
or in the case of a waiver, by the party waiving compliance. No superseding
instrument, amendment, modification, cancellation, renewal or extension hereof
shall require the consent or approval of any person other than the parties
hereto. The failure of either party at any time or times to require performance
of any provision hereof shall in no matter affect the right at a later time to
enforce the same. No waiver by either party of the breach of any term or
covenant contained in this Agreement, whether by conduct or otherwise, in any
one or more instances, shall be deemed to be, or construed as, a further or
continuing waiver of any such breach, or a waiver of the breach of any other
term or covenant contained in this Agreement.

                  13.6 Counterparts. This Agreement may be executed in one or
more counterparts, each of which shall be deemed an original, but all of which
taken together will constitute one and the same instrument.

                  13.7 Arbitration. Any dispute or controversy arising under or
in connection with this Agreement shall be settled exclusively by arbitration,
conducted before a panel of three arbitrators,


                                       14

<PAGE>   15
in New York, New York, in accordance with the commercial arbitration rules of
the American Arbitration Association then in effect. Judgment may be entered on
the arbitrator's award in any court having jurisdiction. The expense of such
arbitration shall be borne as directed by the arbitrator.

     13.8 Severability. The provisions of this Agreement shall be deemed
severable, and if any part of any provision is held illegal, void or invalid
under applicable law, such provision may be changed to the extent reasonably
necessary to make the provision, as so changed, legal, valid and binding. If any
provision of this Agreement is held illegal, void or invalid in its entirety,
the remaining provisions of this Agreement shall not in any way be affected or
impaired but shall remain binding in accordance with their terms.

     13.9 Fees and Costs. The Corporation will contribute not more than $10,000
towards the fees and costs of Employee's counsel in connection with the review
of this Agreement and Michael K. Reicher's Agreement.

     IN WITNESS WHEREOF, the parties have executed this Agreement as of the date
first above written.


ATTEST:                                       HALSEY DRUG CO., INC.


                                              By: /s/ William Skelly
- -------------------------------                   -----------------------------
                                                  William Skelly, Chairman


WITNESS:                                      EMPLOYEE


                                              By: /s/ Peter Clemens
- -------------------------------                   -----------------------------
                                                  Peter Clemens



                                       15







<PAGE>   1
               CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS



We have issued our report dated April 14, 1998, accompanying the consolidated
financial statements included in the Annual Report of Halsey Drug Co., Inc. on
Form 10-K for the year ended December 31, 1997. We hereby consent to the
incorporation by reference of said report in the Registration Statements of
Halsey Drug Co., Inc. on Form S-8 (File No. 33-98396, effective October 19,
1995).




GRANT THORNTON LLP


New York, New York
April 14, 1998









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